The Index Premium and its Hidden Cost for Index Funds
44 Pages Posted: 19 Aug 2008 Last revised: 13 Apr 2010
Date Written: April 8, 2010
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: Suggested Citation