The Truth About Market-Cap Index Funds
As index funds and ETFs have grown in popularity among small investors, fund advisors often fail to fully disclose: One, the impact of small investors money moving in and out of the fund (herding impact). Two, how market cap index funds are constructed. And three, how trading costs and taxes impact results. The biggest benefit to index mutual funds is an investor can invest in a large basket of stocks for very little money, but that is where the benefits end.
The challenge of cap weighting for investors means companies are not removed until the damage to investors is done when companies fall below the market cap requirement. Conversely, companies are often added after their stock prices go up. These changes typically take place quarterly or annually, depending on the index. Other disadvantages of market cap index funds include pooled ownership, trading costs, taxes, control, quality, and down-market recovery.
While some of those items on their own may seem somewhat insignificant, considered in their entirety, they can have a major impact over long periods of time. One of the reasons why the Linden Thomas & Company team built a more efficient index was our affluent clients deserved better! Our Earnings-Focused Institutional Index has many benefits over a pooled market cap index approach.
Earnings Quality, Investor Ownership, and Cost Matter! Earnings Quality over Market Cap
Instead of replacing companies that go below market cap requirements, we apply an earnings quality screen which identifies earnings quality and replaces companies with poor earnings.
Direct Ownership Versus Pooled Ownership
Investors own stocks directly, giving them total transparency and control versus pooled ownership, where investors have no transparency and no control.
Cost and Behavior
The Linden Thomas & Company Institutional Index has no trading costs and no hidden fees. In addition, because our clients own the securities directly, they avoid the negative impacts often seen with pooled mutual funds.
Benefits to our Enhanced Index Approach
- Direct security ownership versus pooled ownership
- Total transparency of holdings
- Earnings quality versus market cap requirement
- No small investor herding impact
- No trading cost
- No phantom taxes
- Ability to gift individual holdings
- Ability to do tax-loss harvesting of holdings
- No high advisor fees