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Selection of an Optimal Index Rule for an Index Fund

Antti Petajisto

New York University (NYU) - Department of Finance; Yale School of Management; BlackRock, Inc

August 31, 2008

Several empirical studies document a substantial price premium for stocks in the S&P 500 index. For index investors this creates a recurring cost: as the index is updated, they need to buy stocks with the premium and sell stocks without the premium. Different index rules can produce different index premia due to the different frequency and criteria of updating. We build a model to investigate the behavior of the index turnover cost and the portfolio performance of a mechanical index fund under a market-cap rule, an exogenous random rule, and a deterministic rule. We find that the rational anticipation of future index composition reflected in prices today eliminates any first-order differences in index fund performance across the three index rules. As the index investors become a large part of the market, the non-index investors become less diversified, and this induces hedging motives which hurt the index investors especially under a market-cap rule.

Number of Pages in PDF File: 50

Keywords: Index premium, index turnover cost, index fund, S&P 500, Russell 2000

JEL Classification: G12, G14

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Date posted: September 8, 2008  

Suggested Citation

Petajisto, Antti, Selection of an Optimal Index Rule for an Index Fund (August 31, 2008). Available at SSRN: http://ssrn.com/abstract=1264698 or http://dx.doi.org/10.2139/ssrn.1264698

Contact Information

Antti Petajisto (Contact Author)
New York University (NYU) - Department of Finance ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0378 (Phone)
HOME PAGE: http://www.petajisto.net/
Yale School of Management ( email )
135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
HOME PAGE: http://www.petajisto.net/
BlackRock, Inc ( email )
400 Howard St
San Francisco, CA 94105
United States
415-670-7911 (Phone)
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