Playing games with index funds

Jason Zweig describes in The Wall Street Journal how your use of index funds get sabotaged by traders. I had no idea this was happening.

Index funds continue to make investing cheaper and easier than ever, he says. For investors in these low-cost, autopilot portfolios that dispense with stock pickers and passively replicate the holdings of a broad basket of stocks or bonds, the best is yet to be.

Here's the problem:

Until now, index funds have had an Achilles' heel. One factor that makes indexing "a horrendous idea," the renowned value investor Seth Klarman of Baupost Group argued earlier this year, is that hedge funds and others have long beaten the index funds to the punch on trades that the autopilot portfolios are forced to make.

Here's a solution:

New "investable" indexes, forthcoming early next year from the Center for Research in Security Prices at the University of Chicago, or CRSP, could reduce compulsory trading for any index funds that adopt them as a benchmark. Funds that trade less should have lower brokerage costs, lower tax bills and higher net returns. Better yet, it should be harder for outsiders to "front run" these improved indexes.

Here's how it works:

Consider an index fund that specializes in small stocks. If the shares of a little company in the fund take off, then the stock won't be small anymore—and the fund will have to sell it. Likewise, the firms that compile market benchmarks periodically add or delete stocks, forcing index funds to buy everything that is added and to sell everything that is deleted. 

CRSP's new family of indexes will tackle the poaching problem in several ways, says Lubos Pastor, a University of Chicago finance professor who helped design them. The boundaries between small, medium and large stocks will be set as proportions of the value of the total market, rather than as fixed dollar amounts or as an unchanging number of companies. Stocks will be "partially weighted," or shared, across different size indexes—so, as a company grows or shrinks, it doesn't have to be added or eliminated in one fell swoop. Any additions or deletions will be made in "packets," or gradual steps over time, and the days on which the substitutions take effect will be randomized.