Editing Index fund (section)

==Disadvantages==

===Losses to arbitrageurs===
Index funds must periodically "rebalance" or adjust their portfolios to match the new prices and [[market capitalization]] of the underlying securities in the [[stock index|stock or other index]]es that they track.<ref name=BloombergFA>{{cite news|title=High-Frequency Firms Tripled Trades in Stock Rout, Wedbush Says|url=http://www.fa-mag.com/news/high-frequency-firms-tripled-trades-in-stock-rout-wedbush-says-8030.html|access-date=26 March 2013|newspaper=Bloomberg/Financial Advisor|date=August 12, 2011}}</ref><ref>{{cite news|last=Siedle|first=Ted|title=Americans Want More Social Security, Not Less|url=https://www.forbes.com/sites/edwardsiedle/2013/03/25/americans-want-more-social-security-not-less-let-them-buy-it/|access-date=26 March 2013|newspaper=Forbes|date=March 25, 2013}}</ref> This allows [[algorithmic trading|algorithmic traders]] (80% of the trades of whom involve the top 20% most popular securities<ref name=BloombergFA/>) to perform [[index arbitrage]] by anticipating and trading ahead of [[Market impact|stock price movements]] caused by mutual fund rebalancing, making a profit on foreknowledge of the large institutional block orders.<ref name=AmeryRebalancing>{{cite news|last=Amery|first=Paul|title=Know Your Enemy|url=http://www.indexuniverse.eu/europe/opinion-and-analysis/7634-know-your-enemy.html?showall=&fullart=1&start=2|access-date=26 March 2013|newspaper=IndexUniverse.eu|date=November 11, 2010}}</ref><ref>{{cite news|last=Salmon|first=Felix|title=What's driving the Total Return ETF?|url=http://blogs.reuters.com/felix-salmon/2012/07/18/whats-driving-the-total-return-etf/|archive-url=https://web.archive.org/web/20120720041358/http://blogs.reuters.com/felix-salmon/2012/07/18/whats-driving-the-total-return-etf/|url-status=dead|archive-date=July 20, 2012|access-date=26 March 2013|newspaper=Reuters|date=July 18, 2012}}</ref> This results in profits transferred from investors to algorithmic traders, estimated to be at least 21 to 28 [[basis point]]s annually for [[S&P 500]] index funds, and at least 38 to 77 basis points per year for [[Russell 2000]] funds.<ref name=Petajisto>{{cite journal|last=Petajisto|first=Antti|title=The index premium and its hidden cost for index funds|journal=Journal of Empirical Finance|year=2011|volume=18|issue=2|pages=271–288|doi=10.1016/j.jempfin.2010.10.002|url=http://www.petajisto.net/papers/petajisto%202011%20jef%20-%20hidden%20cost%20for%20index%20funds.pdf|access-date=26 March 2013}}</ref> In effect, an index, and consequently, all funds tracking an index are announcing ahead of time the trades that they are planning to make, allowing value to be siphoned by [[arbitrage]]urs, in a legal practice known as "index front running".<ref>{{cite web |url=http://www.thetradenews.com/1578 |title=Understanding index front running |access-date=2009-03-24 |work=The Trade Magazine |publisher=The TRADE Ltd. |archive-url=https://web.archive.org/web/20081023004716/http://www.thetradenews.com/1578 |archive-date=2008-10-23 |url-status=dead }}</ref><ref>{{Cite news|url=https://www.bloomberg.com/news/articles/2015-07-07/the-hugely-profitable-wholly-legal-way-to-game-the-stock-market|title=The Hugely Profitable, Wholly Legal Way to Game the Stock Market|newspaper=Bloomberg.com|date=7 July 2015}}</ref> Algorithmic [[high-frequency traders]] all have advanced access to the index re-balancing information, and spend large sums on fast technology to compete against each other to be the first—often by a few microseconds—to make these arbitrages. {{Dubious |reason=I don't think this particular arbitrage opportunity needs particularly fast technology, especially compared to other HFT algos|date=October 2016}} Losses to arbitrageurs appear as "tracking error", the difference between the performance of the index and the fund which is attempting to follow it.

John Montgomery of [[Bridgeway Capital Management]] says that the resulting "poor investor returns" from trading ahead of mutual funds is "the elephant in the room" that "shockingly, people are not talking about."<ref name=Montgomery>{{cite news|last=Rekenthaler|first=John|title=The Weighting Game, and Other Puzzles of Indexing|url=http://www.crsp.com/images/Reprint_Feb_Mar11MornignstarConversation_color.pdf|access-date=26 March 2013|newspaper=Morningstar Advisor|date=February–March 2011|pages=52–56|url-status=dead|archive-url=https://web.archive.org/web/20130729192302/http://www.crsp.com/images/Reprint_Feb_Mar11MornignstarConversation_color.pdf|archive-date=29 July 2013}}</ref> Related "time zone arbitrage" against mutual funds and their underlying securities traded on overseas markets is likely "damaging to financial integration between the United States, Asia and Europe."<ref>{{cite book|last=Donnelly|first=Katelyn Rae|author2=Edward Tower|title=Challenges and Opportunities for Trade and Financial Integration in Asia and the Pacific|publisher=United Nations Economic and Social Commission for Asia and the Pacific|year=2009|pages=134–165|chapter=Chapter VIII. Time-zone arbitrage in United States mutual funds: Damaging to financial integration between the United States, Asia and Europe?|chapter-url=http://www.unescap.org/tid/publication/tipub2563_chap8.pdf|series=Studies in Trade and Investment 67|location=New York|issn=1020-3516}}</ref>

===Common market impact===
One problem occurs when a large amount of money tracks the ''same'' index. According to theory,{{Clarification needed|date=October 2022}} a company should not be worth more when it is in an index. But due to supply and demand, a company being added can have a demand shock, and a company being deleted can have a supply shock, and this will change the price.<ref>{{cite web|url=http://www.iwu.edu/economics/PPE14/Malic.pdf |title=Market Reactions to Changes in the S&P 500 Index: An Industry Analysis |access-date=2014-07-30}}</ref><ref>{{cite web |url=http://www.finance.pamplin.vt.edu/faculty/vs/pdfs/2004JF-ChenNoronhaSingal-SP500Changes.pdf |title=The Price Response to S&P 500 Index Additions and Deletions: Evidence of Asymmetry and a New Explanation |access-date=2014-07-30 |archive-url=https://web.archive.org/web/20140606215238/http://www.finance.pamplin.vt.edu/faculty/vs/pdfs/2004JF-ChenNoronhaSingal-SP500Changes.pdf |archive-date=2014-06-06 |url-status=dead }}</ref> This does not show up in tracking error since the index is also affected. A fund may experience less impact by tracking a less popular index.<ref>{{Cite web |url=http://news.morningstar.com/articlenet/article.aspx?id=689924 |title=Small-Cap Indexing: Popularity Can Be a Pain |access-date=2015-03-26 |archive-date=2015-04-02 |archive-url=https://web.archive.org/web/20150402150257/http://news.morningstar.com/articlenet/article.aspx?id=689924 |url-status=dead }}</ref><ref>{{cite web|last=Arvedlund |first=Erin E. |url=http://online.barrons.com/news/articles/SB114384808690614031 |title=Keeping Costs Down - Barron's |publisher=Online.barrons.com |date=2006-04-03 |access-date=2014-07-30}}</ref>

===Possible tracking error from index===
Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market.

According to [[The Vanguard Group]], a well-run S&P 500 index fund should have a tracking error of 5 [[basis point]]s or less, but a Morningstar survey found an average of 38 basis points across all index funds.<ref>{{cite news |first=Anne |last=Tergesen |author2=Young, Lauren |title=Index Funds Aren't All Equal |url=http://www.businessweek.com/magazine/content/04_16/b3879125_mz070.htm |archive-url=https://web.archive.org/web/20040426102207/http://www.businessweek.com/magazine/content/04_16/b3879125_mz070.htm |url-status=dead |archive-date=April 26, 2004 |work=[[BusinessWeek]] |publisher=[[McGraw-Hill Companies]] |date=2004-04-19 |access-date=2007-02-20}}</ref>
===Asset manager capitalism===
Benjamin Braun<ref name="Braun">{{cite journal |last1=Braun |first1=Benjamin |editor1-last=Hacker |editor1-first=J. S. |editor2-last=Hertel-Fernandez |editor2-first=A. |editor3-last=Pierson |editor3-first=P. |editor4-last=Thelen |editor4-first=K. |title=Asset Manager Capitalism as a Corporate Governance Regime |journal=American Political Economy: Politics, Markets, and Power |date=18 June 2020 |doi=10.31235/osf.io/v6gue |url=https://osf.io/preprints/socarxiv/v6gue |access-date=7 August 2024 |publisher=SocArXiv}}</ref> suggests that, since American stock ownership is concentrated on few big [[asset manager]]s which are very diversified and do not have a direct interest in the performance of the companies, this emerging "asset manager capitalism" is distinct from the earlier [[shareholder primacy]].
The asset managers usually vote with company managers.
Also, as funds invest in most companies in the sector, they would benefit from [[monopoly|monopolistic]] prices.
In an extreme case, there could be economy-wide monopolies where asset managers have "bought the economy".
In a regime of [[common ownership]], while asset ownership is diversified, it is a small part of the population who invest in funds and a top 1% of the wealth distribution owning 50% of [[corporate equity]] and mutual funds.
[[Wage stagnation]] would be an expected [[externality]].
Asset managers have an incentive to increase the assets value and influence [[monetary policy]].