Why Do Funds or ETFs Change The Index they Track?

Some local investors investing in these broad-based indexes may wonder how big of a difference there will be between an FTSE Russell index and an MSCI index.

It is also possible that an ETF or a unit trust that tracks a particular index will switch to another index.

What is the reason?

Daniel Sotiroff over at Morningstar wrote a good piece titled What Happens When an Index Fund Changes Its Target Index?

You would learn something more about your index unit trust or ETFs if you read this piece.

In general, funds don’t keep switching indexes, but it is also not extremely rare.

Daniel showed the difference between funds that switched indexes by their Tracking Error:

Tracking error is measured in terms of percentages and typically tracks the “error” difference between a fund and its benchmark indexes but in this case it is the performance difference of the indexes over the 5 years prior to the change.

To them, less than 3% is considered a small difference.

Some of the reasons funds make index changes:

1. Funds such as Vanguard or Blackrock make index changes due to costs. The funds pay licensing fees to index providers for the rights to track the index. Switching to a different index provider creates opportunity to lower fees which in turn benefits the fund investors.
2. Funds may change to an index that spread trades out over several days. A typical index would have a certain specific rebalancing date which the wide public would know. If you know that this stock is going to be added or remove from the index, you would try to do something to benefit. This works to the disadvantage of the index, and it is why Systematically Active funds like Dimensional have an advantage here. Apparently, there are indexes that swaps out the holdings over several days.
3. The last one is that funds change indexes due to minor details that dictate how and when each index trades its underlying holdings. For example MSCI index reconstitutes its holdings on two days per year while CRSP benchmark spreads its trading activity over four five-day windows.
4. Smaller funds have a bias to change indexes to lower cost or improve performances. The costs affect larger funds less and therefore there are less incentive for larger funds to do that.

If you know this, one conclusion is that two funds can target the same large and mid cap developed markets region but the performances can vary.

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I do have a few other data-driven Index ETF articles. These are suitable if you want to construct a low-cost, well-diversified, passive portfolio.

Systematic Passive Funds

This is a list of articles if you are more interested in investing in funds that track broad-based market capitalization-weighted indexes such as S&P 500, MSCI World, MSCI China etc.

You can check them out here:

1. IWDA vs VWRA – Are Significant Performance Differences Between the Two Low-Cost ETFs?
2. The Beauty of High Yield Bond Funds – What the Data Tells Us
3. Searching for Higher Yield in Emerging Market Bonds
4. The performance of investing in stocks that can Grow their Dividends for 7/10 years
5. Should We Add MSCI World Small-Cap ETF (WSML) to Our Passive Portfolio?
6. Review of the LionGlobal Infinity Global – A MSCI World Unit Trust Available for CPF OA Investment
7. 222 Years of 60/40 Portfolio Shows Us Balanced Portfolio Corrections are Pretty Mild
8. Actively managed funds versus Passive Peers Over the Longer Run – Data
9. International Stocks vs the USA before 2010 – Data
10. S&P 500 Index vs MSCI World Index Performance Differences Over One and Ten Year Periods – Data
11. Why do funds change the index they track?

Here are some supplements to sharpen your edge on low-cost, passive ETF investing:

1. Can You Better Time Your Annual Investment Base on Market Seasonality?

Systematic Active Funds

Those who wish to set up their portfolio to capture better returns believe that certain factors such as value, size, quality, momentum and low volatility would do well over time and are willing to harvest these factors through ETFs and funds over time, here are some articles to get you started on factor investing passively:

1. Introduction to factor investing / Smart Beta investing.
2. IFSW – The iShares MSCI World Multi-factor ETF
3. IWMO – The iShares MSCI World Momentum ETF
4. GGRA – The WisdomTree Global Quality Dividend Growth UCITS ETF
5. Investing in companies with strong economic moats through MOAT and GOAT.
6. Robeco’s research into 151 years of Low Volatility Factor – Market returns with lower volatility that did well in different market regimes
7. JPGL vs IFSW vs Dimensional Global Core vs SWDA – 22 years of 5-year and 10-year Rolling Returns Performance Comparison
8. 98 Years of Data Shows the US Small Cap Value Premium over S&P 500
9. 42 Years of data shows that Europe Small Cap Value premium over MSCI Europe
10. Emerging Markets Small Cap Value Performance