The hidden costs paid by investors while passively tracking a benchmark index

Today, Solactive AG published a new research paper analyzing the additional cost paid by investors in order to passively track a benchmark.

The selection of an index as a benchmark has been tied to the cheap cost to reference it; however, in this research paper, Solactive AG quantifies the additional turnover costs that investors implicitly pay due to arbitrage activity – days before a transparent rebalancing takes place when many assets are tracking the index.

In most cases, it turns out that the additional turnover costs can be as high as the price to track the index.

Timo Pfeiffer

Timo Pfeiffer

Timo Pfeiffer, Head of Research at Solactive, commented:

“Since passive investing is based on rules involving the periodic buying and selling of securities as they are added or removed from a certain index, arbitrageurs can foresee these changes and act upon them.

Any price shocks resulting from arbitrage are passed over to investors in the form of implicit costs. It is thus important to evaluate the impact of these inefficiencies and see what can be done to reduce them.”

Using a Eurozone blue chip index, the paper finds turnover costs are significantly larger than zero. In addition, the paper discusses how turnover costs can be decreased.

The suggested measures include:

1) having multiple indices in the same geography and market,

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.

Click here to access the white paper.

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