The Index Premium and its Hidden Cost for Index Funds

44 Pages Posted: 19 Aug 2008 Last revised: 13 Apr 2010

Antti Petajisto

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

Date Written: April 8, 2010

Abstract

This paper empirically investigates the index premium and its implications from 1990 to 2005. First, we find that the price impact has averaged 8.8% and 4.7% for additions to the S&P 500 and Russell 2000, respectively, and -15.1% and -4.6% for deletions. The premia have been growing over time, peaking in 2000, and declining since then. Second, the implied price elasticity of demand increases with firm size and decreases with idiosyncratic risk, supporting theoretical predictions. Third, we introduce a new concept that we label the index turnover cost, which represents a hidden cost borne by index funds (and the indexes themselves) due to the index premium. We illustrate this cost and estimate its lower bound as 21-28bp annually for the S&P 500 and 38-77bp annually for the Russell 2000.

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

JEL Classification: G12, G14

Suggested Citation

Petajisto, Antti, The Index Premium and its Hidden Cost for Index Funds (April 8, 2010). Yale SOM Working Paper No. 1235604. Available at SSRN: https://ssrn.com/abstract=1235604 or http://dx.doi.org/10.2139/ssrn.1235604

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 )

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San Francisco, CA 94105
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415-670-7911 (Phone)

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