Thu. Jan 20th, 2022

U.S. index tracking funds are throwing away $ 3.9 billion a year using predictable, mechanical trading strategies exploited by smarter market participants, according to academic research.

The losses will cost an investor who has built up a $ 2 million retirement portfolio over 30 years through passive mutual or exchange traded funds $ 29,000, the analysis found.

“The trading costs of mechanical rebalancing are large in many respects. This is comparable to total management fees charged by ETF managers, ”said Sida Li, a PhD student at the University of Illinois and author of the paper.

The research focused on the regular rebalancing, typically quarterly, carried out by passive ETFs to ensure that they remain in line with the changing composition of their underlying index.

Due to the strict methodology of indices, traders know what the index changes are going to be before they are implemented. This gives them the opportunity to advance the trades they know should make rule-based ETFs, and move prices against these funds.

Li found that the majority of US-listed stock ETFs not only announce their rebalancing in advance, but also trade at the 16:00 closing prices on the set index rebalancing days, to minimize the tracking error.

The research also found that the price of the stocks that buy ETFs rose by an average of 67 basis points in the five trading days before the rebalancing, only to fall by 20bp over the next 20 days.

Given that the median portfolio turnover rate for U.S. equities ETFs was 16 percent in 2020, that translates into an average annual performance hit of 14.6 bp.

Li, who described these transparent ETFs’ rebalancing strategies as “sunshine trading”, compared it to what he called “opaque ETFs”. These funds only reported their portfolios at the end of the month, rather than daily, as sunshine ETFs do.

Chart showing the average trading volume for index additions and deletions from 2016 to 2020

However, all ETFs report their net asset value on a daily basis, which allowed Li to compare 16 opaque ETFs that follow identical indices with 16 sunshine indices.

The NAVs of these ETF pairs showed a correlation of 0.9999 outside index rebalancing windows, but only 0.97 during quarterly rebalancing, proving that they traded differently.

Li found that the opaque ETFs made some transactions before the designated rebalancing date and some after. By camouflaging when they traded, they cut an average of 34bp per trade from the execution deficit suffered by sunshine ETFs, equivalent to an annual saving of 7.3bp per year across the portfolio as a whole.

Chart showing intraday trading volumes for S&P 500 additions and deletions on index reconstitution day

The paper also looked at ETFs that “self-index” against an internal benchmark, such as the Schwab 1000 ETF (SCHK) which follows the Schwab 1000 index, which has been allowed in the US since 2013.

These internal indices do not make it clear in advance which stocks will enter or leave an index on a rebalancing, which reduces the ability for others to precede them.

By camouflaging what they trade, these self-indexing ETFs have rebalancing costs that are 30bp a trade lower than those of sunshine ETFs, Li found, equivalent to 9.6bp per year across the entire portfolio.

Ben Johnson, director of global ETF research at Morningstar, said there was “no argument that index rebalancing and restructuring trading are affecting share prices”.

However, he believed the exact extent of the effect was “impossible to measure”.

“You can not control for all the other numerous factors that can affect stock prices at any one time to isolate the market impact of index trading,” Johnson said. “I would say that these estimates are probably many times higher than the actual impact.”

Wes Crill, chief investment officer at Dimensional Fund Advisors, said: “We have done similar studies in the past. All of this suggests that there is a potential added value in having flexibility when doing your transactions.

Long-term indices, such as the S&P 500, were not designed to be tracked by funds, and were originally merely market meters. Nevertheless, Li argued that investors should have an understanding of likely transaction costs and the industry should try to optimize the impact of trading.

One way to do this is to track an index with a lower turnover rate, Li said. Last year, these rates ranged from 5 percent for the S&P 500 to 20 percent for the Russell 2000 and 52 percent for the S&P SmallCap 600 Growth Index, according to the prospects of ETFs they follow. For total market indices, they can be as low as 3 to 4 percent.

Another is to trade in a smarter way. Li pointed to CRSP, an index provider, whose indices rebalance in 20 percent increments over five days, rather than one-time.

Eric Frait, a managing director at CRSP, said he has been using “transition reconstitution” since 2017. “It’s never the case that everything turns around on the same day with the CRSP indices,” he added.

His colleague Alexander Poukchanski, director of index analysis, said the idea was based on how active managers trade. “The goal for these indices must reflect what active managers actually do. This is a philosophical change, “he said.

CRSP has also introduced a concept called “packeting” to reduce revenue. This allows a share close to the cut-off point between, for example, middle and small capitalization points to be included in part in each index, which reduces the trading that would have occurred previously when the share of index changed.

Johnson said a series of measures have adapted their methodology to either reduce the impact of trade or, “to borrow the author’s term, ‘camouflage’ their trades”.

Li believed it was worthwhile for investors to look for ETFs that keep trading delays to a minimum. “I believe that investors who invest in low-turnover ETFs can achieve lower index rebalancing costs. [and] the cost savings could be as large as the management fees, ”which is an average of 15.1bp for US equity ETFs, he said.

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