Episode 355 – Do Index Funds Incur Adverse Selection Costs?

Marco Sammon joins Ben and Dan to unpack his latest paper, ‘Index Rebalancing and Stock Market Composition’, beginning with how Marco’s work (co-written by John Shim) compares to the Nobel Prize-winner Bill Sharpe’s paper, ‘Arithmetic of Active Management.’ We investigate the missing links in Sharpe’s logic before defining “the market” and ascertaining the main objectives of index funds. Then, we dive deeper into the mechanics of Marco’s paper, index and market tracking errors, why delayed rebalancing is more beneficial than instant rebalancing, and the role of technology in the modern tracking error obsession. We also assess the passive-active spectrum of index funds in portfolio management and learn how investors should choose their optimal excess return. To end, Marco shares practical applications for improving performance benchmarked against traditional indexes, and The Aftershow is all about bridging the gap between PWL Capital and you, our listeners.

Key Points From This Episode:

 

(0:00:00) Key takeaways from Marco Sammon’s latest paper and how it compares to Bill Sharpe’s ‘Arithmetic of Active Management.’

(0:08:10) Marco describes what’s missing from the ‘Arithmetic of Active Management’ logic.

(0:09:11) Defining ‘the market’, the main objective of an index fund, and how index funds track the market.

(0:15:57) The mechanics of Marco’s paper, ‘Index Rebalancing and Stock Market Composition.’

(0:18:38) Factor exposure, index and market tracking errors, and how often index funds trade.

(0:26:28) Rebalancing less frequently; why delayed does better than instant rebalancing.

(0:31:59) The tech run-up and lazy rebalancing, and the modern tracking error obsession. 

(0:36:51) Assessing the passive-active spectrum of index funds in portfolio management.

(0:41:02) Exploring how investors should decide on their optimal excess return. 

(0:45:14) How the rising index fund ownership of stocks impacts the implicit cost of indexing

(0:46:58) Practical ways to improve performance benchmarked against traditional indexes.

(0:52:30) The Aftershow: Canadian finances, more airtime for Cameron, and PWL – OneDigital. 

 

Links From Today’s Episode:

Meet with PWL Capital — https://calendly.com/d/3vm-t2j-h3p

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/ 

Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/

Rational Reminder on X — https://x.com/RationalRemind
Rational Reminder on TikTok — www.tiktok.com/@rationalreminder

Rational Reminder on YouTube — https://www.youtube.com/channel/

Rational Reminder Email — [e-mail]
Benjamin Felix — https://pwlcapital.com/our-team/

Benjamin on X — https://x.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Dan Bortolotti on LinkedIn — https://www.linkedin.com/in/dan-bortolotti-8a482310/

Episode 322: Prof. Marco Sammon: How are Passive Investors Affecting the Stock Market? — https://rationalreminder.ca/podcast/322

Episode 200: Prof. Eugene Fama — https://rationalreminder.ca/podcast/200 

Episode 268: Itzhak Ben-David: ETFs, Investor Behavior, and Hedge Fund Fees — https://rationalreminder.ca/podcast/268 

Episode 112: Michael Kitces: Retirement Research and the Business of Financial Advice — https://ra