Introduced just over 40 years ago, index funds are now firmly middle-aged, but still growing like an adolescent. Both index funds and their cousins, exchange-traded funds, have been marketed as inexpensive and partly as a result garnered huge asset inflows over the past 10 years. According to Morningstar, in 2016 alone, these passive index funds and ETFs attracted more than $504 billion in new assets, while actively managed funds posted withdrawals of $340 billion
Index funds and ETFS do have low expense ratios, but are these costs paid to the sponsors of these funds to manage the investments the only expenses paid by investors?
Our research strongly suggests institutional investors are unaware of significant hidden costs embedded in the reporting of the results of passive investments, particularly those made up of Standard & Poor's 500 stock index companies. Investors and money managers crowding into these vehicles aren't clearly presented with two ongoing, long-term costs that affect total returns.
Our research into the dilutive costs of equity stock buyback programs and stock-based compensation found they add an average of 4.1% annually to the costs of owning an index fund built to mimic the S&P 500. Collectively we refer to the costs of equity stock buyback programs and stock-based compensation as “look-through expenses.”
Our research into the S&P 500 examined two factors:
1. The average annual dilution from each company's executive equity compensation plan. To arrive at this, we calculated the dilution from executive compensation plans by averaging it over the typical three- to five-year year vesting period. On average for the index, it amounted to 2.5% in 2015.
2. The average annual buyback for each company. We found that, on average, 53% of the shares purchased in stock buyback programs for S&P 500 companies were used to offset the dilution from executive equity bonus plans. This amounts to average annual buyback being used to offset dilution from equity compensation plans of 1.6% in 2015.
The market values at play are huge: The equity market capitalization of the S&P 500 was over $20.2 trillion at year-end 2016, and 4.1% of this amount exceeds $828 billion. That's right — S&P 500 investors are paying more than $828 billion in murky expenses.