Index Reconstitution: Hidden Investing Costs

With the annual reconstitution of the Russell indices once again approaching, this is an opportunity to revisit the effect of index reconstitution events upon returns for an expanding universe of ‘low cost” index funds increasingly popular among investors.

Here we illustrate a substantial cost for index investing of which few investors are informed. Basketball coaching legend John Wooden once said: “It’s the little details that are vital. Little things make big things happen.” The natural corollary might be, little things make bad things happen.

Index funds have been an innovative investing solution of the past 40 years that provide diversified stock and bond portfolios with low published expense ratios. Due to recent Department of Labor regulations. 401k plans have been aggressively adding index funds to participant selections, eliminating high-cost managed funds. On any given day, an investor can observe the performance of dozens of indices from providers such as MSCI,1 S&P,2 or Russell3—and monitor whether or not an index fund manager replicated the index’s performance (gross of fees and expenses). However, strict adherence of index fund managers to stated indexes comes at a substantial cost due to restricted trading discretion around publically announced “reconstitution” dates.

Most indices revise their list of index constituents periodically (e.g., annually or quarterly). At that time securities may be added or deleted from the index by its provider. This process is commonly referred to as index reconstitution. For example, the annual reconstitution of the widely tracked Russell indices will occur on June 24, 2016. Russell index fund managers, or indexes adhering to the Russell indexes, must buy additions and sell deletions for the specific Russell indices they mimic in order to minimize tracking error4 relative to the index. Any deviation of the fund from the index, over days or even hours, could result in significantly different returns from the underlying index. Over the years, in a perverse version of political correctness, some index managers suggest that tolerating any deviation from an underlying index is somehow a moral wrong.

PFS_exhibit1_VFHJune16

The effect on volume from index rebalance trades is evident from a huge volume spike on index reconstitution day. Exhibit 1 illustrates average trade volume for additions and deletions in four major indices during the 80-day period surrounding the reconstitution date. Each of the charts shows a marked increase in trade volume on the effective date of reconstitution relative to the surrounding days. The effect is pervasive across the market capitalization spectrum as well as geographic regions.

For each index, this large liquidity event from a forced change in demand tends to drive up the prices of those securities with greater purchase demand (generally additions to the index) relative to the other securities in the index. It also tends to push down prices of securities with greater sell demand (generally deletions from the index) relative to the other securities in the index. Thus, for an index being tracked by a large amount of assets such as the popular S&P 500 index, the index has generally added securities at higher prices and deleted securities at lower prices than it would have if no assets had been tracking it. This phenomenon is the solely result of index managers’ expected demand for liquidity on or around the index reconstitution date. Furthermore, in anticipation of publically announced demands, informed hedge fund managers and other traders systematically exploit their knowledge of those publically announced events days before and after to the detriment of underlying index fund shareholders.

After the reconstitution of an index, as the liquidity demands of index managers decline, research shows this negative pricing effect reverses to equilibrium market conditions. That is, additions tend to underperform the index while deletions tend to outperform. As a result, index managers’ implicit trading costs result in a performance drag on the stated index and, consequently, on those funds precisely tracking that specific index. This market impact is not part of mutual fund or ETF expense ratios. As such, it creates a hidden cost of index investing. Also, the trading techniques a particular fund manager on that date easily may be adversely impacted by market trading costs due to illiquidity.

PFS_exhibit2_VFHJune16

Exhibit 2 illustrates how substantial the hidden trading costs of “passively” managed index funds may be as they compete with other index funds and hedge fund managers and traders exploit the easy profit opportunities periodically presented by publically disclosed “reconstitution” dates.

A simple experiment in delaying reconstitution allows us to estimate how much this price pressure has impacted index performance. Exhibit 2 compares average monthly returns for two sets of Russell indices; one set is rebalanced on the June-end reconstitution date and the other three months later. As shown in the final three columns, delaying rebalancing improved average returns between 0.15% and 0.73% per month from July through September—the three months between the rebalance date of the standard indices and their delayed counterparts. For all calendar months, including October through June when holdings are identical for both rebalancing methods, this amounts to a performance benefit ranging from 0.04% to 0.18% per month, or approximately 0.45% to 2.21% per year. We suggest that, without incentives to keep undisclosed costs low, the theoretical returns from index investing strategies generally are not realized in practice.

SUMMARY

Index funds may be an option for some investors seeking investments with low fees relative to high-cost conventional actively managed funds with erratic style drift that make planning asset allocations difficult. But implicit trading costs from market impact—not only the pennies per share for today’s trades—can significantly erode potential indexing advantages, especially for those funds invested in in smaller US stocks and for international stocks where trading costs are much higher. Consequently Index funds’ goal of minimizing tracking error inadvertently reduces potential investor returns.

Because of high liquidity demands around index reconstitution dates, many index funds incur trading costs that do not appear in published expense ratios—but significantly reduce realized returns. Reconstituting an index only once a year, as many index funds do to advertise low expenses ratios, may reduce returns further due to style drift during a twelve month period between annual reconstitutions. Identically matching the underlying index may be disingenuous approach due to its increasing popularity, concealing substantial costs of increasing trading inflexibility.

Informed investors should consider both direct and implicit costs, both expense ratio and implicit trading costs, when planning investing decisions. Choices may be limited if index funds are the only ones available in a company retirement plan line-up. When possible, consider an investment approach that using defined assets classes based on dimensions of the capital markets using financial science, and that uses a smart trading approach flexible enough to selectively sell or purchase representative shares at lower prices—and opportunistically taking advantage of wealth transfers during the periodic trading demands of index funds.

  1. Morgan Stanley Capital International.
  2. Standard & Poor’s Index Services Group.
  3. FTSE Russell is wholly owned by London Stock Exchange Group.
  4. Tracking error is the standard deviation of the return differences between a fund and its benchmark.