Wed. Jan 26th, 2022

Passive – or index investing – has exploded in popularity over the past decade. But the trillions of dollars that flowed into index-following investment vehicles also gave rise to a popular new trade: index forerunner.

Indices tracked by exchange traded funds are regularly rebalanced – usually every quarter – with securities added or removed. Key metrics such as the S&P 500 telegraph change days, if not weeks, in advance. To minimize tracking errors, ETFs adjust their holdings just before the changes take effect. The passage of time means opportunistic traders can make a profit by simply buying stocks before joining the indices, and reselling them on the day when index funds have to buy them.

A new academic paper reckons this practice creates a hidden cost for holders of US-listed equity ETFs worth $ 3.9 billion a year, mainly in the form of higher trade expenses. Because transaction costs are not included in the expense ratio that an ETF charges its shareholders, it can ultimately reduce a fund’s performance. These additional rebalancing expenses could increase the holder’s index fund cost by as much as 60 percent, according to the research.

Yet these figures require some context. Over the past two decades, investors have been the clear winners on investment fees. Average spending ratios paid by fund investors fell by more than half to 0.41 percent in 2020, largely due to passive investment, says Morningstar. The asset-weighted average expenditure ratio for all U.S. domiciled ETFs was 0.18 percent in 2020, compared to 0.3 percent in 2011.

Large fund managers also have many ways to mitigate higher execution costs. At Vanguard, the second largest ETF provider, this includes equity lending and participation in syndicated equity offerings. Funds can also choose to adjust portfolios gradually over days to minimize arbitrage opportunities.

Investors buying from ETFs do not necessarily seek to maximize profits, as much as convenience. Despite hidden rebalancing costs, ETFs still offer it.

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