While that might not sound like a lot, the added cost would be almost three times the stated 0.11 percent management fee for the $213 billion Vanguard 500 Index Fund, the largest S&P 500 tracker fund of its kind. By comparison, actively managed stock funds charge an average 0.86 percent annually, data compiled by Investment Company Institute show.

“The moment you say index, you’re telling the world you’re going to be trading on this particular day,” said Eduardo Repetto, co-chief executive officer at Dimensional Fund Advisors, a fund firm that designs passive strategies that differ from traditional index funds by giving higher weightings to factors such as profitability. “If you have zero flexibility when you trade, it’s going to cost you money.”

‘Being Smart’

Studies paint a similar picture of what happens to benchmarks around the world -- from Japan’s Nikkei 225 Stock Average to the FTSE 100 Index in the U.K. and MSCI Inc.’s global equity indexes -- when their members are reshuffled.

Bloomberg LP, the parent company of Bloomberg News, creates, licenses and administers indices for multiple asset classes that may compete with other index providers.

Some fund management firms are working to combat the problem. Managers at Vanguard Group, which oversees $3 trillion, “mitigate a good portion” of the risk by gradually building positions over time in stocks that are scheduled to be added, said Doug Yones, the Valley Forge, Pennsylvania-based firm’s head of domestic equity indexing and ETF product management.

“It just comes down to being smart with your trades,” he said. “It’s a big enough deal that index managers are aware and spend time and energy making sure there isn’t an impact.”

For its part, S&P says it doesn’t dictate when index funds buy and its re-balancing process ensures everyone gets the same information at the same time.

More Efficient

“We don’t require them to trade in a certain way,” said David Blitzer, chairman of the index committee at S&P Dow Jones Indices. “That’s their business not ours.”

What’s more, arbitragers may provide liquidity for passive funds because they “assemble a lot of stock,” he said.

Dimensional’s Repetto says his Austin, Texas-based firm, which manages almost $400 billion, avoids buying stocks immediately before they go into an index. Instead, fund managers purchase them earlier or after the fact.

While the strategy increases “tracking error,” or industry-speak for how much index fund returns diverge from benchmarks, it can also help fund managers boost performance.

Dimensional’s $5.7 billion DFA U.S. Large Company Portfolio fund has done just that. Its annual return exceeded Vanguard’s comparable flagship S&P 500 index fund by 0.11 percentage points a year over the past decade, even as its tracking error has been seven times as great.

Buyer Beware

Petajisto and Morningstar’s Rawson also suggest passive funds that buy the entire market can minimize the damage of front-running. By owning almost every stock, there’s barely anything for arbitragers to buy first.

Vanguard’s $411 billion Total Stock Market Index Fund is the most prominent example. In the past decade, it has returned 8.2 percent a year, beating the firm’s own S&P 500 tracker fund by 0.4 percentage points, data compiled by Morningstar show.

That might not mean much now with U.S. equities well into its sixth year of gains, but the risk is that savers may be far less forgiving once the bull market falters.

“Because the performance has been good and the fees are low, they’re not noticing some of these potential flaws in indexing,” said Morningstar’s Rawson. “But it’s not something that should be ignored.”
 

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