🎉 Happy S&P 500 Rebalance Day!
Hi there,
John here with one that I hope will demystify a little corner of investing and help you understand what’s potentially in your portfolio. Today, we’re talking stocks and indexes. An index is just a list of stocks and their associated weights in the index. An index fund buys all the stocks in the index in order to track the index as close to perfectly as possible. One of the main points of indexing is to remove all relative performance uncertainty. If you own an index fund, you’re basically certain to get the index return minus the costs of the fund. The benefit of the index fund is that it’s cheaper and easier to run than a fund that has to make decisions about what stocks to buy and in what weights. That work is outsourced to the index provider who runs the index based on a “rulebook”. As a result, index funds are generally very cheap when it comes to the management fees and other explicit expenses. For instance, the expense ratio on the Vanguard S&P 500 ETF (VOO) is just 0.03%. But there are downsides to indexing too. Like most things in life, there are trade offs that should be made with eyes wide open, hence the newsletter today.
⚖️ What's the trade off?
One of the downsides of indexing is that anyone and everyone can know what’s in the index at any given time. So when indexes announce changes, professionals often get ahead of those changes in anticipation of massive increased/decreased demand for the stock from index funds on rebalance day.
Pretty much every quarter, there are a spate of headlines reacting to stock moves related to S&P 500 index changes. The latest headlines highlight Crowdstrike, GoDaddy, and KKR as new additions to the index. These companies will replace Comerica, Illumnia, and Robert Half Inc. on June 28th when the index does its quarterly rebalance. The headlines typically go something like this, “________ rises/falls on announcement it will be added/dropped to/from the S&P 500”. For example, here are some sample headlines from this quarter’s upcoming rebalance:
Source: Wall Street Journal
Source: Kiplinger
Source: The Motley Fool
💸 What's the impact?
If you currently own an S&P 500 Index fund, you can be sure you do not own CrowdStrike as of this writing, but will be buying it on June 28th after its recent rise due to the inclusion announcement. This phenomenon has been studied in depth by academics and practitioners1. It’s referred to as the “index rebalance effect” and the gist is that additions to indexes tend to outperform the market leading up to inclusion, then underperform after inclusion, while names dropped from the index do the opposite. Of course there are many other things happening in the world besides index rebalancing that can affect stocks, so unfortunately this is not an infinite money hack. However, it is potentially an implicit cost of using index funds. The estimates for the size of the index rebalance effect (i.e. how much performance it costs you) vary. But from first principles, it makes sense that it’s not zero. Anytime you are an inflexible buyer or seller, you're at risk of getting less than the best deal. Inflexibility is a real cost that isn’t expressed in the sticker price of the fund. That cost may be worth it to you, but it’s probably a cost you didn’t realize you were implicitly paying for the certainty of tracking the S&P 500 Index.
🔗 What to do about it?
In short, combine different investment solutions to build a portfolio that fits with your goals, and the specific risks you're taking in your life (e.g. working at a startup). Figuring out how to do just that is what I do. To do it well, I believe it requires an understanding of the person and the tradeoffs inherent in any investment decision. My goal is to always help folks understand what tradeoffs I’m making and why. My hope is that this approach will help people reach their goals faster, with less anxiety, and more investment discipline. For even more info on why “just buy index funds” might miss the mark, take a look at a previous newsletter I authored on so-called passive investing.
At the end of the day, I don’t believe there are “best” investment solutions, only different tools for different jobs in your overall portfolio.
Things we’re digging:
- 👾 I attended the Stardew Valley Concert in Austin this past weekend. It was amazingly well done and another impressive feat of the game's creator Concerned Ape.
- 💻Raspberry Pi went public in London last week at 280p and is now trading around 440p.
- 📐Incentives matter. Be careful what you measure!
1 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=303279