Editor’s note: A version of this post ran in 2015. We believe it’s an important topic for advisors that is worth revisiting.

 

Isaac Newton’s third law of motion states that for every action there is an equal and opposite reaction. Never in my professional career would I have imagined that a physics-related concept would motivate me to undertake a research project aimed at explaining the performance of index funds!

The popularity of indexing and ETFs has ignited a newfound emphasis on index fund due diligence. The most common due diligence process is one that provides a list of metrics, including—but not limited to—expense ratio, excess return, and assets under management, and then requires investors to pick through those metrics to determine whether the index fund is any good.

This approach never made sense to me for two reasons:

  1. Investors should start by measuring excess return and tracking error when gauging an index fund’s ability to track its index.
  2. Investors should then view the other often-cited metrics as potential causes of excess return or tracking error.

In other words, investors shouldn’t necessarily look at the expense ratio and excess return independently, because the expense ratio has a direct impact on excess return. Put in Newtonian terms, the action of a fund charging an expense ratio causes the reaction of a lower excess return.

The research, published in The Journal of Portfolio Management,1 analyzes the effects that several “action” variables have on the two “reaction” variables of excess return and tracking error, and because the sample consists of ETFs, excess return and tracking error are analyzed on both a net asset value and a market price basis. Admittedly, it’s not the case that every action exactly causes an equal and opposite reaction, but it is the case that the expense ratio is the dominant variable that explains excess return and that active share is one of the statistically significant variables that explains tracking error.

If Newton were alive today and an indexer, I would hope that he’d find this analysis useful when trying to select index funds. I hope you do as well.

 

1 Subscription to The Journal of Portfolio Management required.