Index Rebalancing and Stock Market Composition: Do Index Funds Incur Adverse Selection Costs?

Abstract

We find that index funds incur adverse selection costs from responding to changes in the composition of the stock market. This is because indices rebalance directly in response to composition changes to maintain a value-weighted portfolio, both on the extensive margin (IPOs/delistings or additions/deletions) and intensive margin (issuance/buybacks). This rebalancing approach successfully tracks the market as it evolves, but effectively buys at high prices and sells at low prices. Using several long-short portfolios, we estimate that both intensive-margin and extensive-margin rebalancing trades lead to around a -4% return per year, though only the intensive-margin portfolio’s return is robust to factor exposures. Despite representing less than 10% of index funds’ AUM, these rebalancing portfolios do poorly enough to drag down overall index fund returns. We estimate that a “sleepy” strategy that is less responsive to changes in the stock market’s composition improves fund returns by 20 to 80 bps per year, and is monotonically increasing in how sluggishly it responds to compositional changes. We argue this is because sleepy rebalancing avoids the short- and medium-term adverse selection associated with relatively quickly taking the other side of firms’ primary and secondary market activity. Our findings highlight a large cost incurred by passive investors that simply wish to track the total stock market. And, our proposed simple alternative stock index design boosts returns by an order of magnitude more than typical index fund expense ratios.

Keywords: Index Funds, Index Providers, Issuance, Buybacks, Rebalancing

JEL Classification: G11, G23