Index investors are paying a hidden cost during reconstitution events in the form of lower returns, according to a report from Dimensional Fund Advisors.
Over the past decade, passive investing has been growing rapidly as investors have flocked to funds that track benchmark indices at a lower cost.
2023 marked a significant milestone as passive equity fund assets surpassed active equity assets globally for the first time.
This has been a boon to the likes of BlackRock and Vanguard who offer low cost index funds that track benchmarks. These are the same benchmarks which many actively managed funds have struggled to beat.
But as the sheer volume of assets that now track a benchmark index grows larger, it has resulted in some market distortions.
It is creating a growing but hidden cost of index replication, according to a report from Dimensional Fund Advisors authored by Kaitlin Hendrix, Jerry Liu, and Trey Roberts.
Lost returns due to index replication
During reconstitution events (when stocks are added or removed to indices) index fund managers must adjust their holdings to match the new composition of the benchmark index.
In the effort to have as little deviation as possible from the index, index funds concentrate their trading on the day index providers update their weightings.
This has negative consequences for end investors that isn’t measured as a cost, but has been measured in the form of returns.
The Dimensional report examined the costs of index reconstitution between 2014 and 2023 for five widely tracked global indices: the FTSE 100, S&P/TSX 60, S&P/ASX 300, EURO STOXX 50, and Nikkei 225.
It found that leading into reconstitution, index additions tend to outperform and deletions tend to underperform their respective indices, while both exhibit reversals following reconstitution.
Put simply, stocks that have been announced as index additions outperform before they’re added, and then underperform after they’re added – meaning index funds miss out on the gains and then suffer the losses.
More specifically, the report found that cumulative excess return to additions and deletions was 3.5%, on average, in the 20 days leading up to reconstitution.
Over the 20 trading days following reconstitution, additions and deletions see a reversal of around 1.9%, on average.
“The rigidity of having to trade specific securities in specific amounts on specific days forces index funds to demand immediacy, which comes at a cost,” the authors explained.
“This cost is not reflected in expense ratios of index funds but detracts from their returns because it’s priced into the returns of the indices.”
This phenomenon is worse in US indices, where the same authors found in a similar study that the excess return was 4% for the additions, followed by a 5.7% reversal within the next month.
The authors said: “With respect to transaction costs, adhering to an index reconstitution schedule can result in relatively poor execution prices—buying higher and selling lower—which are in turn reflected in investors’ returns.”
They suggest that one way to avoid these costs would be to rebalance portfolios across all trading days within the year, flexibly across stocks, quantities and time.
“Such an approach can help investors target higher expected returns while also managing risks and costs in the global opportunity set,” they said.
