Solactive has published a research paper analysing the additional cost paid by investors in order to passively track a benchmark.
The firm writes that index arbitrageurs anticipate index adjustments beforehand and take opposite positions, thus bidding up (down) the prices of additions (deletions).
“Consequently, at rebalancing, the index tracking investors pay (receive) higher (lower) prices for the additions (deletions). These are implicit costs associated with index turnover: the index turnover costs. Using a Eurozone blue chip index, we quantify the turnover costs for nine ordinary rebalancing days considering different lookback periods of five, 10, 20 and 40 days prior to these rebalancing days. We find average turnover costs ranging from 12 to 36 basis points.”
The firm then ran a statistical bootstrap and simulated 10,000 turnover costs. “Given these simulations, we observe that the turnover costs are significantly larger than zero. We further decompose the turnover costs using the Fama & French five-factor model. Our results indicate that the excess returns of the additions and deletions are partially explained by their factor exposure, thus implying that the turnover costs are significantly larger than zero (between nine to 32 basis points and in line with the results of the second point).
“We conclude that index turnover costs can be reduced by 1) having multiple players in the indexing business, 2) reducing the index turnover by adding turnover constraints into the index creation’s methodology and 3) implementing a transparent rebalancing procedure with a long buffer time before the rebalancing date.”
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