In 1991, Nobel laureate William Sharpe dropped a bombshell on the finance world with a paper arguing the “average” active manager will always lose out to passive strategies after fees.
His insights helped pave the way for a more than $10 trillion index-fund frenzy over the next three decades, yet they hinged on some key assumptions -- including that active managers “must pay more for trading.”
But it’s not like index investors get their shares for free.
In the last few minutes of trading on Friday, equity volumes will explode as funds managing trillions adjust for the annual reconstitution of the FTSE Russell indexes, instantly making this one of the busiest days of 2022. And if one recent research paper is correct, a majority of them will be paying nearly three-times the going rate for every trade -- costs that could be lessened with a few simple strategies.
The exact cause of this surge in costs is up for debate, with some saying nimbler players are exploiting the predictable purchases of index funds by buying first. Others say flatly that there is nothing to see here -- that it’s natural to pay more for such big adjustments. But the upshot is that it’s getting tougher to dismiss passive trading costs.
“The cost is really large and the pattern is statistically significant,” said Sida Li, assistant finance professor at Brandeis International Business School, who wrote the study called “Should Passive Investors Actively Manage Their Trades?”
In it, Li -- then a PhD student at the University of Illinois Urbana-Champaign -- crunched data through 2020 to show that a share rises 67 basis points on average in the five days before it’s bought by a transparent U.S. equity exchange-traded fund and slips 20 basis points in the subsequent 20 days. The 67 basis-point “execution shortfall” he found compares to 24 basis points for other institutions, according to an earlier research paper.
The idea is that passive vehicles are hitched to the public rebalance schedules of indexes like the S&P 500, so when stocks are added to the gauge, the trillions tracking it have to snap them up typically on the same day. That bombards the market with such massive and predictable orders that the funds end up paying a premium.
“It’s important because for mom-and-pop traders, they just buy and hold,” Li said by phone. “They don’t realize there are transaction costs associated with the ETFs.”
He isn’t the first to document this kind of phenomenon -- other academics and researchers have fretted over these kinds of distortions for years. In fact, last July FTSE Russell itself announced an internal review of its rebalance frequency.
Turnover during the 2021 reconstitution jumped 45% from a year earlier, the firm said after the event. It noted that “a record 2.37 billion shares representing $80.8 billion were executed in the Nasdaq Closing Cross in 1.97 seconds, while 2.1 billion shares were traded on NYSE -- their fifth largest NYSE Closing Auction ever, with $105.1 billion in notional value traded.”
A spokesperson at the London Stock Exchange Group, which owns the FTSE Russell indexes, said there’s no update on their review.
Bloomberg LP, the parent company of Bloomberg News, competes with FTSE Russell to offer index products for various asset classes.
Li’s claim that arbitrageurs are pushing up trading costs is a contentious one. To Antti Petajisto, who documented the so-called index effect -- where stocks enjoy a bump in performance after being added to an index -- as a finance professor at New York University in 2010, Li’s results show there’s a case for spreading rebalancing trades across the day or even a few days. But he stresses transparency is actually a win-win for both arbitrageurs and ETF providers.