Glasses of water

Not ALL Milk and Honey - Index Fund Managers and the Not So Delicate Rebalance

Glasses of water

Maybe you thought the average index fund manager had a pretty cushy job. After all, they are not out there in the front line trenches picking off portfolio stocks like the managers of active mutual funds. Talk to an index fund manager, though and he'll tell you he's got plenty to do.

"Smoothing the effects of rebalancing is one of the most important roles an index fund manager plays," says Roderick Baldwin, Fund Manager of California Investment Trust S&P 500

"We try to use our knowledge to determine when we trade and we move the old stock out and the new one in on the same day. And while we always strive to add value, generally after a forced rebalancing. the fund evens out. Capital gains tax ramifications can sometimes be a challenge, particularly in a big cap fund. We do some tax lot selling."

Not all fund managers buy and sell the appropriate stocks immediately. Vanguard representatives state that they balance their fund over a prolonged (and of course undisclosed) period of time. It is easy to measure a fund's end performance both in terms of net returns and tax efficiency.

Unlike the more murky waters of active fund management, the results of index fund managers are right there for everyone to see - with the relevant index anchored as an indisputable benchmark. And how did Mr. Baldwin fare? Judge for yourself:


Exp. Ratio %

1yr annual %

3y annual %

5yr annual % 1yr after-tax % 3yr after-tax % 5yr after-tax %
S&P 500 Index - 7.25 19.66 23.79 - - -
Vanguard 0.18 7.31 19.67 23.76 6.78 18.92 22.85
Schwab 0.35 6.88 19.21 - 6.46 18.79 -
Fidelity 0.19 7.09 19.47 23.51 6.57 18.64 22.34
California 0.20 7.28 19.66 23.66 5.64 18.24 21.94
Barclays 0.20 6.82 19.33 23.46 4.49 17.40 21.65


Source: Morningstar Inc.

Since index funds are comprised of the stocks chosen by established indexes, the managers dance to the beat of somebody else's drum -- the people who create and maintain the indexes.

An index fund's performance will pretty closely mirror the performance of the index it tracks, such as the S&P 500 with its 500 largest and most profitable companies. or the Russell 2000 with company stocks chosen for market capitalization rates. Not a lot here to trigger an adrenaline rush.

But, periodically the drumbeat signals the next rebalancing of the index and everything that goes with it. It's the "everything that goes with it" that begins to shake things up a bit. It's called the "S&P Effect."

If the stock performance of any company currently on an index fails to meet the standards, it's cut loose. Such was the fate of S&P 500's ailing drug store chain Rite-Aid earlier this month. Did you hear the drums? That was the sound of a rebalance in motion.

Every time a stock is cut from the index, it also is cut from the index funds, and chances are some active mutual fund managers are going to drop it as well. So it goes with stocks on the decline and the investors holding the bag.

When an index begins courting the next big winner, the effect will inevitably be felt on that stock's equity price, brief though it may sometimes be -- and consequently, it can affect the amount to be spent for purchasing the required proportional holdings by the index fund.

For example, on July 19, Standard and Poor's announced their intention to bring JDS Uniphase Corp., the largest maker of parts used in fiber-optic equipment, into the fold. JDSU stock soared 20 percent on the news. Because of its market cap of around $87 billion, it officially entered the capitalization-weighted S&P 500 with a very high ranking. That meant funds which were based on that index had to cough up over $6.3 billion to pick up their share of JDS Uniphase stock. The move even caused the S&P 500 index itself to reach a whopping $800 billion.

It's not just the S&P 500 rebalancing that stirs things up. This year the predicted changes in the Russell 2000 small stock index created a much bigger shift in share prices than in the past and it did so weeks before the final list was actually released or any stocks actually were moved in. The fervor in activity was due in part to the fact that nearly 600 companies are set to join the index and 280 of those hadn't even gone public until this year. Market cap for these stocks will be around $1.6 billion.