The Avoidable Costs of Index Rebalancing
43 Pages Posted: 6 May 2022
Date Written: May 3, 2022
Traditional capitalization-weighted indices generally add stocks with high valuation multiples after persistent outperformance and sell stocks at low valuation multiples after persistent underperformance. For the S&P 500 Index, in the year after a change in the index, additions lose relative to discretionary deletions by about 22%. 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 (bps). This benefit doubles when we cap-weight a portfolio not selected on market value, but based on the fundamental size of a business or its multi-year average market cap.
Keywords: Indexation, Portfolio Construction, Passive Investing, Transaction Costs, Optimal Trading.
JEL Classification: G11, G12, G14, G23
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