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April 02, 2020
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I've oft described there are nuances to the investment process that add to the returns that are lost upon those who only focus on the internal costs of index funds. The mistake many investors make is, as I've pointed out before is while focusing on the pennies at their feet they are missing the dollars scattered all about them. How so?

Here's a simple case in point where over the years a trading strategy of a managed asset class fund (similar to an index fund and often described as a index fund on steroids) has it all over a pure index fund and this can yield an important difference in returns over time.

Let's take a case of what just occurred yesterday. Macy's, a member until now of the S&P 500 has declined about 70% this year. This has caused it to be unceremoniously dropped from the index and relocated to the small cap index. This is to occur on April 6th. Obviously when one stock is dropped another must take it's place. Thus, enter Carrier Global.

Now, for the uninitiated, a pure index fund -- likely the ones you're most familiar with -- must exactly track the index it represents. Thus, the constituent stocks must remain both in content and proportion to the index itself so that no "tracking error" might occur. This insures the index fund will move exactly the same as it's representative index minus the index fund costs.

So what's the nuance? An asset class fund such as we use in our portfolios is under no such constraint to exactly track a particular representative index. It is managed so that if advantageous tracking error can be allowed to occur - in other words, if there is a benefit to be gained by delaying the sale or addition of a stock to their fund, even if for a period of time it deviates from the index, it will be allowed.

Getting back to the Macy's / Carrier Global event of being removed/added to the S&P index. Since these two stocks have to be in one case sold and the other added on April 6th, what do you think will happen to the price of these stocks when every index that owns them has to reconstitute to either remove or add them?

Correct: as all head to the exit at the same time to unload Macy's this will cause the price of the stock to fall that day. And when Carrier Global is added to the index the all have to buy that stock this will cause the price of the stock to rise. In other words, given the large blocks to be sold less money will be received upon the sale and conversely it will be more costly to acquire shares.

A patient seller or buyer of a stock for an asset class fund, who can wait some period of time before either selling or buying, until a market stabilizes for the stock, will (as several academic studies have shown) sell the stock at a higher price and buy the added stock at a lower price when those who "have" to buy or sell have exited the marketplace. This, trading advantage over time translates into higher returns than an equivalent index fund and even in some cases the index itself.

Sometimes it's not the knowns or even the unknowns that can cost you but rather, as is illustrated by this particular nuance, the unknown unknowns. The additional returns that accrue to the asset class fund more than make up for any cost differential and in many cases the advisor fee as well!

Related to this tracking cost issue, one of my guilty, secret pleasures is watching saved programming of The People's Court. Presiding Judge Milian, who is of Cuban descent has a favorite saying in Spanish she advises victims who appear before her as a warning, which also applies to investors as well: "la barata siempre sale caro!" Translated:

THE CHEAP ALWAYS COMES OUT EXPENSIVE!!!

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Frederick C Taylor
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