Why doesn't an index fund that tracks an index consistently outperform the index?
Why doesn't an index fund that tracks an index (like the S&P) consistently outperform the index? I understand the fee structure to pay for turnover as well as for minimal management. However, shouldn't the fund profit enough off of stock leasing to a short seller to generate enough returns to outperform the actual index?
Index funds are not designed to outperform indexes. They're designed solely to track or replicate a specific index. Keyword here is 'track', not 'outperform'. The other keyword here is 'index fund', not 'mutual fund.' Unlike mutual funds, index funds are passively managed, meaning there's no team of portfolio managers actively buying and selling in attempt to beat the market or picking specific securities over others in the underlying portfolio. Most index funds will either own every asset in that specific index it's seeking to track or seek to achieve the same end result by holding similar securities. As a result, there's no picking winners or losers, you're simply buying up an entire index and then participating in, not beating, it's performance. Here's a good Investopedia article on how index funds work.
An index funds job is to track the index closely with as little tracking error as possible period. Now you would be happy if it beat the index, but that would mean the fund is doing a poor job just as if was underperforming the index. The index is just a published group of stocks with absolutely now costs or transactions. So you really cannot "own"the index, but rather a surrogate.
While it is true the Fund could generate some small interest in lending shares, but that would help to offset transactions & other trading cost.
Hope this helps and best of luck, Dan Stewart CFA®
First, an index fund is meant to track the index, never exceed it. To outperform an index, an investor must do something different than the index itself. You suggest stock leasing as part of an extra return strategy; and leverage introduced to an index strategy does have the potential to bring added return, but then it is no longer an index fund, but a leveraged investment strategy. When a fund takes on leverage strategies of any kind, the fund must disclose this.
Additionally, most index funds own a computer calculated subset of the index stocks. An S&P 500 index funds could own as few as 19 stocks by some models. Most own more than this and each fund uses its own model to achieve the tightest fit to the index- measured as R-squared, and reported more commenly as tracking error.
Finally, there will be always be some management fee in a fund that the index does not pay. In total, the bottom line is that an index is often viewed as an unrealistic mark for an investor. An investor does not pay for turn over when components change; it does not pay taxes on dividends; nor does it pay transaction costs for reinvested dividends. Over the long run, an index does not have to withdraw funds to pay for college, retirment or debts, nor invest at various times as a real person builds savings.
This is all to suggest, be an informed index investor and understand what your expectations should be over time for successful investing.
Great question! These are some of the complexities of what many people tout as the simplest way to invest. Strictly speaking, the goal of these funds is to minimize tracking error, not to perform well. I certainly wouldn't expect them to outperform a pure index, since indices incur none of the operational costs of a business. You should expect an index fund to underperform it's benchmark by it's expenses, at least.
There are many ways to build an index fund; some are holding the actual companies of the index; some are synthetic funds not holding any of the actual stocks. There are still humans running these funds, and in many cases, making decisions about what and how much to hold. All of this can easily account for performance differences.
To your specific question, stock leasing revenue is not required to be brought back into the fund as profit. It's not price growth and it's not dividends, so if it doesn't come back into the fund, where does it go? Ferraris? Yachts? Seriously though, it doesn't typically go into investor's pockets, unless the company explicitly states that it does!
Don't get me wrong - an appropriate allocation of several index funds will perform better and be simpler than most of what DIY investors are doing (stock pickers, market timers, and S&P 500 index holders, I'm looking at ALL of you)! But, simpler for most people and best for you are two different animals.
Other than the fees you mentioned, the other cause of underperformance comes from over diversification. The whole idea is that you can only diversify a portfolio to a point where risk can't be reduced any further by diversification. Refer to the Efficient Frontier for these levels which defines the maximum expected return for a given amount of risk. Once you are at the optimal level of diversification each additional stock will essentially cause your portfolio (index fund in this case) to retract to the mean of the market (index) minus the fees you pay. Because these funds own a couple hundred stocks, they are well past the optimal level of diversification causing the portfolio to retract to the mean of the market (index).