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Millions of investors have taken advantage of index investing to produce low-cost, market-matching returns for decades. And with some new innovations in indexing, one of its major shortcomings may soon become a thing of the past.

The biggest cost of index funds
Nothing could be simpler than index investing. Pick an index, buy all of its component stocks in the appropriate proportions, and sit back and hold them for the long haul. There are no timing rules about when you're supposed to buy and sell, and for the most part, you don't have to trade in and out of stocks. That recipe has delivered huge returns for many investors over the years.

The flaw of index investing lies in the way that underlying indexes are created and managed. Old companies go out of business, and new ones rise up to take their place. Mergers and acquisitions combine two separate businesses, freeing up space for new blood to take the resulting open spot in the index. Because of these changes, the overseers of major market indexes must remain constantly vigilant to make sure their index products accomplish the goals they set for themselves.

Obviously, index overseers have to maintain their indexes. But the way they do it now is incredibly disruptive to the market.

Index change day
Consider two different ways that major indexes update themselves. On one hand, Standard and Poor's adopts an ad hoc approach to index management. It makes moves to its indexes without any predetermined schedule; when something happens that warrants a change, S&P will act appropriately to make sure its indexes reflect current events. Inevitably, though, S&P gives at least a few days' notice before the proposed change is reflected in the indexes. That gives hedge funds, institutional investors, and even small-investor speculators the chance to front-run the index change, buying shares in the hope that forced buying from index funds will drive up prices even further.

On the other hand, Russell Investments regularly updates its indexes every June. The multi-week process involves several stages, wherein Russell warns investors about which companies are likely to move from one index to another based on then-prevailing circumstances. Closer to the rebalancing date, Russell makes final changes, and then index funds that track those indexes have to make moves based on them. With $3.9 trillion indexed to Russell benchmarks, including the small-cap benchmark ETF iShares Russell 2000 (NYSE: IWM  ) , it's not surprising that investors hang on every move.

Inevitably, both methods create market distortions. For instance, during this year's Russell rebalancing, Sirius XM Radio (Nasdaq: SIRI  ) was slated to be added to Russell's large-cap 1000 index, prompting shareholders to anticipate a big bull run for the satellite radio company. Other companies affected by Russell's June move included both large companies Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) and General Growth Properties (NYSE: GGP  ) as well as small-caps Jamba (Nasdaq: JMBA  ) and Kodiak Oil & Gas (NYSE: KOG  ) .

Making a change
That's why some new indexers are coming up with a different strategy for creating a front-running-proof method. As the Wall Street Journal wrote about earlier this week, the University of Chicago's Center for Research in Securities Prices (CRSP) plans to come out with indexes that beat the front-running problem. Rather than having fixed boundaries between different investing styles, the indexes will use proportional weighting to ease companies in and out of various indexes, reducing the impact of a change. And when changes are made, they'll be done in several parts, giving index funds the chance to manage their exposure more smoothly.

The question is whether index fund managers will start using the new CRSP indexing methods. Yet with the popularity of ETFs, which are constantly looking for new, innovative ways to invest, it should be child's play to find a manager willing to take a flyer on the CRSP method.

Index funds have been a great way for investors to make money in the market. With the potential benefits, new index funds based on the CRSP methodology might well prove to be a vast improvement on an already excellent way to invest.

ETFs are a great way to implement an index-investing strategy. Click here to read The Motley Fool's free report, 3 ETFs Set to Soar During the Recovery.

Fool contributor Dan Caplinger wants a better index for Christmas. He owns shares of Berkshire Hathaway and iShares Russell 2000 ETF. The Fool owns shares of Berkshire Hathaway, which is a Motley Fool Inside Value pick and a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy has its methodology down pat.

Read/Post Comments (1) | Recommend This Article (5)

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  • Report this Comment On December 08, 2010, at 7:50 PM, Banderson33 wrote:

    These CRiSPy indexes should reward buy and hold investors enough to discourage at least a few arbitrage seeking day traders from taking money out of the market without really adding any value to the underlying. I hope that we can start a revolution (cue the eye roll) to revert back to the old ways of holding for a few years at a time.... Where's General Benny Graham when you need him?

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