Passive ETFs hit by billion dollar rebalancing costs

According to academic research, US index funds waste $ 3.9 billion a year using mechanical and predictable trading strategies that are exploited by more nimble market players.

The losses would cost an investor $ 29,000 who built a 30-year $ 2 million retirement portfolio through passive or exchange-traded mutual funds, according to the analysis.

“The cost of negotiating mechanical rebalancing is high in many ways. It is comparable to the total management fees charged by ETF managers, ”said Sida Li, a PhD student at the University of Illinois and author of the article.

Research has focused on the regular, usually quarterly, rebalancing that passive ETFs perform to ensure they stay aligned with the changing composition of their underlying index.

Due to the strict index methodology, traders know what the index changes will be before they are implemented. This gives them the ability to make the trades they know rule-based ETFs need to make, moving prices against those funds.

Li found that the majority of US-listed equity ETFs not only advertise their rebalances in advance, but also trade at 4:00 p.m. closing prices on stipulated index rebalance days, in order to minimize l ‘tracking error.

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The research also found that the price of stocks bought by ETFs increases on average by 67 basis points in the five trading days leading up to the rebalancing, only to drop 20 bps over the next 20 days.

Given that the median portfolio turnover rate for U.S. equity ETFs was 16% in 2020, this translates to an average annual performance of 14.6 bps.

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

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

However, all ETFs report their net asset value daily, which allowed Li to compare 16 opaque ETFs that track identical indices to 16 sunny ones.

The NAVs of these ETF pairs exhibited a correlation of 0.9999 outside the index rebalancing windows, but only 0.97 during quarterly rebalances, showing that they were trading in a different way.

Li found that Dark ETFs make some transactions before the designated rebalance date and others after. On average, by camouflaging themselves during their trades, they reduced by 34bp a compromise on the execution deficit suffered by the Sunshine ETFs, which is equivalent to an annual saving of 7.3bp per year on the whole. wallet.

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

The paper also looked at “self-indexed” ETFs against an internal benchmark, such as the Schwab 1000 ETF (SCHK) which tracks the Schwab 1000 index, which has been permitted in the United States since 2013.

These internal cues don’t make it clear in advance which stocks will enter or exit an index during a rebalance, reducing the ability of others to lead them.

By camouflaging what they trade, these self-indexed ETFs have rebalancing costs of 30bp, lower trade than Sunshine ETFs, Li found, which equates to 9.6bp per year across the board. wallet.

Ben Johnson, director of global ETF research at Morningstar, said there was “no argument that rebalancing and rebuilding indices has an impact on stock prices.”

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

“You can’t control all of the myriad other factors that can impact stock prices at any given time to isolate the market impact of index trading,” Johnson said. “I would say these estimates are probably multiples of the actual impact.”

Wes Crill, Head of Investment Strategies at Dimensional Fund Advisors, said: “We have done similar studies in the past. All of these indicate that there is potential added value associated with 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 only market indicators. Nonetheless, Li argued that investors should have an understanding of likely transaction costs, and the industry should try to maximize the impact of trade.

One way to do this is to follow an index with a lower turnover rate, Li said. Last year those rates ranged from 5% for the S&P 500 to 20% for the Russell 2000 and 52% for the S&P SmallCap 600 Growth Index, according to the ETF prospectuses that follow them. For total stock indices, they can be as low as 3 to 4 percent.

Another is to trade smarter. Li pointed out CRSP, an index provider, whose indexes rebalance in 20% increments over five days, rather than all at once.

Eric Frait, director general of CRSP, said he has been using a “transitional replenishment” since 2017. “It is never the case that everything changes on the same day with the CRSP indices,” he added.

His colleague Alexander Poukchanski, director of index analysis, said the idea was based on the way active managers trade. “The focus of these indices should reflect what active managers actually do. It’s a philosophical change, ”he said.

The CRSP has also introduced a concept called “packeting” to reduce turnover. This allows a stock close to the borderline between, say, mid and small caps to be partially included in each index, reducing the trading that would have already taken place when the stock changed index.

Johnson said a series of benchmarks were adapting their methodology to minimize the impact of trading or, “to borrow the author’s term,” to camouflage “their trades.”

Li felt it was worthwhile for investors to look for ETFs that minimized the drag of trading. “I think investors who invest in low turnover ETFs can reduce the costs of index rebalancing. [and] the cost savings could be as big as the management fee, ”which averages 15.1bp for US equity ETFs, he said.

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