More Active Than You Think | The Active Nature of Index Construction

January 16, 2025

For many investors, investing in an index fund is a “no brainer” way to get exposure to markets or asset classes.

But a white paper from Dimensional, titled “Indices Acting Active: Index Decisions May Be More Active than You Think” and authored by senior investment director and vice president Karen Umland, argues that investors should be putting more thought into their index investment choices.

“Different index providers make different methodology choices,” notes Umland, which means that even indexes based on the same asset class can have significantly different returns. For example, looking at the S&P SmallCap 600, the Russell 2000, and the CRSP US Small Cap indexes over the 20-year period ending 2023, the best-performing index earned on average 4.9% more than the worst-performing index. In 2009, the year with widest performance gap, the CRSP index gained 40.1% while the S&P index rose just 25.6%, a performance differential of over 14 percentage points.

Umland discusses the three critical areas where construction methodology can have a significant impact on index performance:

• Stock eligibility. Index providers must determine when to add stocks to an index and when to remove them, and they must establish an approach to weighting the stocks in the index. These methodology decisions can have “consequences for returns in a manner similar to stock selection decisions by active managers,” says Umland. She cites the example of Tesla which was added the S&P Dow Jones almost a year before it was added to the S&P 500, to the detriment of the S&P 500’s relative performance.
• Country eligibility. Similarly, for multi-country indexes, providers have to decide which countries to include and what weight to assign to them. Indexes targeting similar asset classes can have quite different country exposures. Most notably, South Korea is included in the MSCI Emerging Markets IMI Index (and is one of the larger country exposures in that index) but has no weight in the FTSE Emerging All Cap Index (since FTSE considers it a developed market).
• Index providers must also determine rebalancing frequency. More frequent rebalancing helps to ensure that the index remains representative of the market or asset class that the index tracks. For instance, the number of large-cap stocks included in the smaller-cap Russell 2000 index increases at a fairly steady pace between the index’s annual rebalancing dates. But more frequent rebalancing can generate high trading costs.

In short, the decisions made by index providers “shape the investment exposure and returns for index investors.” As a result, Umland concludes, “it is important for index investors to perform due diligence on decisions made by their index provider.”