Index Funds And The Damage They Can Cause

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Index investing has become a powerful force on Wall Street over the last decade or two. It's influence has spread to the point where highly focused indexes are being used by investors as a way to gain exposure to a market segment without the need to pick individual stocks. This sounds good on the surface, but there is a dark side to this ease. A good example was provided recently when Alerian, a provider of indexes that track limited partnerships, made a change to one of its more popular index products.

What A Difference A Day Makes
On Dec. 18, 2012, Alerian announced that it was making a change to the Alerian MLP Index. It was a simple switch, bringing in Holly Energy Partners (NYSE: HEP) and jettisoning Inergy LP (NYSE: NRGY) to make room. These types of changed happen all the time and with the transition of Inergy to, effectively, a General Partner instead of a Limited Partnership, the move made complete sense. However, the impact on the shares of the two companies was notable. As you would expect, Holly advanced and Inergy declined.

Indeed, the graph below is typical of what happens when a stock is added to an index and when a stock is removed from an index. The pattern is kind of frightening, as it displays the power that index investing has over stocks.

<img src="http://media.ycharts.com/charts/01925d5e5c181cbd51d6d2a4a09ade3f.png" />

HEP data by YCharts

Unequal Equals
A few years ago Ron Baron of the Baron Funds made note of what he viewed as the negative impact of the indexing phenomena at his annual shareholder's meeting. Essentially, he believed that good stocks were being muddled with lesser quality stocks. He reasoned that the stocks you would probably prefer to avoid were being afforded valuations that were more appropriate for higher quality companies because they were being put on an equal footing in the index, which basically forced index funds to buy them.

This issue wasn't such a big deal when there were only a few big indexes, and they either didn't change all that often (The Dow Jones Industrial Average, where over three years passed between the last two changes), or were so large (The S&P 500, for example) that a few regular changes were inevitable because of corporate actions alone.

Sure, there were price jumps when changes were made, but such changes weren't frequent enough to matter. And the prestige of being added to the index was big news on Wall Street and Main Street. However, with the advent of the exchange traded fund (ETF), which at its birth was largely index-based, we've seen a proliferation of highly specialized, and far less glorious, indexes.

An Index For Everyone
The Alerian Index, for example, tracks large master limited partnerships. It's a relatively hot sector right now, making the change even more material for the share price of the effected stocks. I only noticed because of the price drop of Inregy LP, an parternship I happen to own. Looking at the ETF universe, however, quickly shows that indexes get very specialized. There's one for private equity, biotechnology, solar power, Indian consumer goods stocks, Chinese real estate, and on, and on, and on. If you have an investment niche, there's probably an index to go with it.

Some of these indexes, however, are only in existence for the ETF to which they are related. The company that created the index receives an ongoing licensing fee from the ETF sponsor for the privilege of using the index.

For many companies, that fee amounts to virtually free money, since they usually already have the data or a notable name brand. The only thing that the index creator had to do was mine their databases to create back-tested performance data that could be used to support the sponsor's sales efforts. Or, even worse, simply allow their name to be used to give an index credibility that it may or may not have deserved.

For the sponsor, they just want to offer products that bring in enough assets to make them a profit, so the index isn't really as important as a good story.

It doesn't take long to figure out that this model is prone to abuse. So, Baron's concerns make complete sense. And, with the index model being championed by folks like Vanguard's John Bogle and many highly respected educators, the whole ETF industry has a veneer of purity. No one seems to care about the distortions that the explosion of indexes can have on the market.

Holly or Inergy?
The difference in Holly's business between Dec. 17 and Dec. 18 was nonexistent. It was the same exact company with the same exact corporate outlook. The share price advance was related only to its inclusion in the Alerian index. The same thing goes for Inergy, except that it was dropped from the index and its shares fell. The price change was simply too large to be justifiable. Either Inergy was being afforded a premium that it didn't deserve (and Holly priced at a discount), or the index inclusion (exclusion) was the sole reason for the premium (discount).

While there isn't likely to be a change in index investing any time soon, there is good reason to be careful about using indexed investment options as the core of your portfolio. If you include too many niche indexes, your portfolio is likely filled with stocks with price distortions. It doesn't seem realistic to expect those distortions to last forever. For investors favoring individual stocks, it might make sense to look for those companies being pushed out of indexes to see if the almost inevitable price decline is truly deserved.

Kraft (NASDAQ: KRFT), which was just recently removed from the Dow 30 to make room for UnitedHealth Group (UNH), has gone through a major transformation. Although the folks who create the Dow 30 may believe that a health care provider is more representative of the U.S. industrial sector, that doesn't mean that a newly focused Kraft can't provide a material benefit to investors looking for exposure to mature markets as a way to generate income. With a nearly 4.5% yield, now could be a good time to spend the time to better understand the changes at this industry giant.

So What?
Note that the Alerian index change was announced on the 18th, with the actual change taking place at the close of business on the 21st. Thus, the bulk of the price change in each company's shares occurred before the index change. So the index investor, essentially, suffered the price decline in Inergy and had to pay more for Holly than it otherwise would have had the index change not been pre-announced. It looks like those distortions might matter more than index investors would like to believe.

Yours,

<img height="103" src="/media/images/user_14110/signiture_large.jpg" width="205" />


ReubenGBrewer has a position in Inergy LP. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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