Index Changes and Unexpected Losses to Investors in S&P 500 and Russell 2000 Index Funds
Department of Finance, University of Central Florida
University of Washington, Tacoma - Milgard School of Business
We find that, due to arbitrage around index changes, investors in S&P 500-linked funds lose between 0.03% and 0.12% annually, while investors in Russell 2000-linked funds lose between 1.30% and 1.84%. In dollar terms, the losses range from $3.75 billion to $6 billion a year for the two indexes together.
These losses are an unexpected consequence of index fund investors evaluating index fund managers based on tracking error in an effort to control agency costs. Minimization of tracking error coupled with the predictability and/or pre-announcement of index changes creates the opportunity for a wealth transfer from index fund investors to arbitrageurs, particularly for Russell 2000-linked funds where the index changes are predictable. We propose solutions aimed at resolving the problem that can be implemented by indexing companies, index fund managers, or fund investors.
Number of Pages in PDF File: 52
Keywords: Index funds, Index changes, Agency costs
JEL Classification: G23, G32
Date posted: January 22, 2005