This video examines the hidden costs associated with index funds, despite their low fees. Ben Felix argues that while index funds are generally excellent investments, their rigid adherence to index tracking can lead to significant, often overlooked costs that exceed the benefit of low fees. He explores research demonstrating how this impacts returns.
Hidden Costs of Index Funds: Index funds, while lauded for low fees, incur significant costs from adverse selection, price impact during index reconstitution, and mean reversion. These costs are often overlooked but can substantially reduce returns.
Adverse Selection: Index funds buy stocks when companies want to sell (e.g., during IPOs or seasoned equity offerings) and sell when companies want to buy (buybacks), resulting in a negative return. This is especially true during periods of high market valuations.
Price Impact of Index Reconstitution: The predictable buying and selling behavior of index funds around index changes (additions and deletions) creates temporary price pressures, causing funds to buy high and sell low. While this effect has lessened over time, it still represents a cost.
Counterfactual Index Funds and Delayed Rebalancing: Studies using counterfactual index funds that delay rebalancing show that a more flexible, less mechanically driven approach can significantly improve returns, sometimes by as much as 0.81% annually. The Dimensional Fund Advisors (DFA) US total market fund (DFUS) is presented as a real-world example of a flexible, non-indexed approach that outperforms comparable index funds.
Dimensional Fund Advisors (DFA) as an Example: DFA's US total market fund (DFUS) serves as a practical example of an alternative approach that avoids some of the pitfalls of traditional index funds. It offers similar broad market exposure but with a more flexible rebalancing strategy, leading to potentially better performance.
