Easy money exploiting the index funds?

You’ll occasionally see articles like this one claiming that it’s relatively easy to exploit index funds with the following strategy:

  1. Figure out which stocks will be added to a widely tracked index, such as the Standard & Poors 500.
  2. Buy them before they are added.
  3. And then sell them when they’re added to the index, at a time when index funds are required to add them also, pushing their prices up.

So, does that mean “buy and hold index funds” is a bad strategy? Hardly. The index funds know about this (surprise!) and so they begin building their holdings of likely index additions well in advance. The loss to index fund investors is minimal, leaving index fund returns still well above the averages and the alternatives.

In that same article you’ll notice the recommendation of two analysts to buy total market index funds to get around the problem:

Petajisto and Morningstar’s Rawson also suggest passive funds that buy the entire market can minimize the damage of front-running. By owning almost every stock, there’s barely anything for arbitragers to buy first.

The fund they cite is the exact one I recommend, the Vanguard Total Stock Market Index fund. The conclusion — you’re not surprised, are you? — is: Buy and hold index funds.