Why Investing in Index Funds Is More Expensive Than You Think

NEW YORK (TheStreet) -- Insider Monkey can understand why index funds are so popular. Index funds don't eliminate the unnecessary and harmful costs of investing but they significantly minimize them. Investing in index funds is not passive investing and there are some hidden costs that index fund investors must bear.

The most common index funds are the ones that track the S&P 500 (SPY, IVV, etc.) and Russell 2000 (IWM) indices. Even though these index funds are not actively managed, the indices themselves are actively managed.

The S&P 500 index is composed of the 500 largest companies. However, the ranking of the 500 largest companies in America changes nearly every second as stock prices fluctuate up and down. This isn't a big deal for companies that are at the top of the rankings. However, at the bottom of the table, some companies drop out of the list while other companies manage to sneak into the top 500. As a result, the S&P periodically makes public announcements, drops some companies from the list and adds others. What do you think happens before and immediately after these announcements?

Since managers sheepishly follow the indices' portfolio weights in order to minimize their tracking error. They hold on to the dropped companies till the last second while nimble traders sell them days or weeks before they're dropped. They also don't start buying the newly added companies until they're officially added while nimble traders already have the new stocks in hand.

Since most of these trades were artificially induced, they are lopsided and cause big market impacts. Dropped companies underperform, newly added companies outperform around the event date, and guess who foots the bill? Yep -- index fund investors. A 2006 study estimates the annual cost to index fund investors is between $1.0 and $2.1 billion.

One might think that this is a small price to pay as long as the new companies that are included in the index can beat the "loser" companies that are dropped out of the index. But another study analyzed the impact of index rebalancing on returns of the Russell 2000 index. A buy-and-hold index portfolio (the one that keeps the losers and does not include any new companies) outperformed the annually rebalanced index in the 1979-2004 period by an average of 2.22% over one year and 17.29% over five years.

So, no -- investing in index funds is NOT a low cost strategy. Stop making Bogle and other Bogleheads rich and start using your brain. Stay tuned to Insider Monkey for our take on several stock market anomalies that lead to much higher returns than index funds.

This article was originally published at Insider Monkey.

RELATED STORIES:

Should We Invest in Dividend Stocks for the Long Term?

What the Roubini Sentiment Index Is Saying

Become a fan of TheStreet on Facebook.

Meena Krishnamsetty is the editor of Insider Monkey, a Web site that provides free real-time insider-trading data. Insider Monkey houses a finance blog with commentaries and evidence based articles on the intricacies of investing and market anomalies. Insider Monkey also provides a hybrid evaluation system that exploits the market's insider transactions.