The Avoidable Costs of Index Rebalancing

Abstract

Traditional capitalization-weighted indices generally add stocks with high valuation
multiples after persistent outperformance and sell stocks at low valuation multiples after persistent
underperformance. It’s well-known that the price impact of these changes can be large once a
change is announced. The subsequent reversal is less well known. For example, in the year after a
change in the S&P 500 Index, discretionary deletions beat additions by 22%, on average. Simple
rules, such as trading ahead of index funds or delaying reconstitution trades by 3 to 12 months,
can add up to 23 basis points a year. This benefit roughly doubles when we cap-weight a portfolio
selected based on the fundamental size of a company’s business or on its multi-year average
market-cap.

Keywords: Indexation, Portfolio Construction, Passive Investing, Transaction Costs, Optimal Trading.

JEL Classification: G11, G12, G14, G23