When a typical index fund launches it is tracking an index that has existed for less than four months © Getty Images/iStockphoto

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Newly constructed indices often flatter to deceive and rapidly lose the bulk of the ability to outperform they demonstrated in backtesting, according to research from Morningstar.

Based largely on backtested data, a typical new index outperformed its corresponding Morningstar category index by 1.4 percentage points a year during the five years before any fund started tracking it, the researchers found. But that excess total return declined to just 0.39 percentage points a year over the five years after the fund launched. Risk-adjusted performance followed a similar downward trend.

“Indexes tend to experience a drop in performance after a fund starts tracking them,” the researchers concluded.

Peter Sleep, senior portfolio manager at Seven Investment Management, said the findings were unsurprising.

“A lot of smart beta products [ie those not based on market capitalisation-weighted indices] were a product of data mining optimised on historic data and therefore investors should not be surprised if they did not deliver similar levels of alpha [outperformance] as in the backtest,” Sleep said.

The researchers also noted that most indices have shortlived records — when a typical index fund launches it is tracking an index that has existed for less than four months, the researchers found.

They looked at the target indices for nearly 1,000 mutual and exchange traded funds that encompassed a wide array of asset classes and classifications, including US and global equities, fixed income and commodities. They included traditional broad market cap-weighted indices, but also smart beta, environmental social and governance (ESG) considerations and narrow thematic benchmarks.

Only 262 had three years of returns before their fund’s launch and the findings relating to the drop-off in performance related to this subset.

Daniel Sotiroff, senior manager research analyst at Morningstar and lead author of the report, said his team had found nothing to contradict previous academic findings that on average and over the long term broad passive funds outperform actively managed funds.

“But these smaller passive funds — they tend to start to look like active funds at the end of the day,” he said.

The Morningstar research also found that the median number of stocks held by an index-tracking equity fund had declined from about 500 at the end of 1998 to less than 150 by the end of 2022.

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Sotiroff pointed out that many recent launches had been “narrow, volatile thematic funds, chasing the hot parts of the market” and that investors should have been applying caution anyway.

Todd Rosenbluth, head of research at VettaFi, however, said that investors appeared to using the different tools available to them in a sensible manner.

“Few investors are owning just narrowly constructed ETFs,” he said. Instead he said most are employing funds tracking broad market cap-weighted indices as the building blocks of their portfolios and complementing them with thematic or smart beta strategies.

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