Secrets of S&P 500 index funds: They're not all alike

January 31, 2022 8:36 PM

More than seven in 10 American investors see low-cost index funds as the best way to build long-term wealth, according to a Sept. 2021 Gallup poll.

Are they?

Over two decades, the asset management industry’s biggest players have preached a simple message to mainstream investors: Forget the high costs of traditional mutual funds, whose managers seek to nail superior returns through bespoke trading strategies. Instead, go in on cheaper, outperforming index funds run by a computer program that replicates the ups and downs of a benchmark, like the Standard & Poor’s 500 index of blue-chip U.S. companies. The pitch: Sitting back to “passively” mirror the ups and downs of an established formula bags you more money over the long haul.

But the passive principle is not as clear cut as millions of investors and advisors think. Index funds come both as mutual funds and tax-efficient exchange-traded funds (ETFs are like a mutual fund but trade just like a stock). And their returns can vary widely.

New “closet activist” index funds pick winners and losers and hide their daily holdings, just like a mutual fund. Conversely, some high-cost mutual funds are indexers in disguise. Even the performance of plain-vanilla funds that track the same benchmark vary. Last October, the SEC warned investors about sketchy practices related to fees, investing strategies and performance in some index, mutual and exchange-traded funds.

It's complicated

Passive investing has captured the minds of investors.

Hidden in plain view?

Some mutual funds that claim to be sifting through scores of stocks are instead secretly tracking well-known indexes. Those “closet indexers” cost more for investors, even though their managers aren’t picking diamonds and dumping rocks. That makes their overall returns typically lower than those of plain-vanilla index funds.

There’s a flip side to that wrinkle. Some index funds don’t do as well as their actively managed peers. One in three index mutual funds and index ETFs falls into that underperforming group, according to a March 2021 paper by academic researchers.

The lag is most pronounced in funds that mirror niche or proprietary indexes — in other words, not in household-name rosters of blue-chip companies, like the S&P 500, the world’s most widely followed benchmark. The lag is also prevalent in funds that track measures of themes, such as sustainability or diversity. The paper by three researchers at the University of Toronto calls those underperforming index funds “closet activists.” They may be index funds — a byword for lower costs and superior returns — but they can have gains that are nearly 1 percentage point lower than their peers.

The upshot for advisors: “The pervasive perception is that index funds and ETFs are passive, and that one passive fund is largely interchangeable with another,” the paper said. “This perception is unwarranted.” The takeaway: “While the more passive ‘closet indexers’ underperform in the world of active management, the more active ‘closet activists’ underperform in the passive space.”

Old-school grand-daddies

The number of funds tracking the S&P 500, widely regarded as the broadest measure of the U.S. stock market, peaked in 2000 at 101, according to Cerulli data. Since then, there are fewer of them, but they have greater assets. Cerulli counted 61 funds that listed the S&P 500 Index as its primary benchmark in securities filings as of the end of last year, including four ETFs. But the firm notes that the figure may include funds that started out doing something other than tracking the index or that use borrowed money. Morningstar Direct counts 42 “pure” S&P 500 index funds, including four ETFs, with a collective $2.6 trillion in assets.

Not all equal

Morningstar Direct said that the 10-year annualized return through last December for index funds in all forms ranges from 14.61% (for the Rydex S&P 500 H) to 16.49% (for the iShares S&P 500 Index K). The nearly 2% difference means that $50,000 invested in the Ryder fund would hand an investor just over $195,500 after a decade, while the same amount in the iShare fund would yield more than $230,000 — a roughly $34,500 difference.

The fees charged by mutual funds range widely, so it’s not surprising that returns for those funds vary, even if they’re passively following a benchmark.

What about returns by the four low-cost ETFs? They also vary in their performance, even though they’re roughly charging the same low costs and following the same benchmark.

Blame benchmark-tracking glitches and their lucrative practice of lending stock to big banks, a move that can paradoxically cause a fund that passively mirrors an index to, in fact, beat that index.

Track this

Sometimes an index fund’s underlying portfolio of stocks, bonds or other assets swerves from its corresponding benchmark. When that happens, usually when markets turn volatile, it’s known as “tracking difference” and “tracking error.” The bigger those values, the more a fund isn’t following its benchmark in lock step and may be producing lower returns.

Tracking difference refers to how much a fund’s performance veers from that of its benchmark over time. The measure is most valuable to investors concerned with a fund’s total gains. By contrast, tracking error refers to the consistency of those differences. That computation is most useful for investors focused on the consistency of a fund’s performance.

Which raises a question: How can an investment fund that automatically tracks a benchmark veer from its benchmark