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Index Changes and Unexpected Losses to Investors in S&P 500 and Russell 2000 Index Funds

52 Pages Posted: 22 Jan 2005  

Honghui Chen

Department of Finance, University of Central Florida

Gregory Noronha

University of Washington, Tacoma - Milgard School of Business

Vijay Singal

Virginia Tech

Date Written: March 2005

Abstract

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.

Keywords: Index funds, Index changes, Agency costs

JEL Classification: G23, G32

Suggested Citation

Chen, Honghui and Noronha, Gregory and Singal, Vijay, Index Changes and Unexpected Losses to Investors in S&P 500 and Russell 2000 Index Funds (March 2005). Available at SSRN: https://ssrn.com/abstract=651950 or http://dx.doi.org/10.2139/ssrn.651950

Honghui Chen

Department of Finance, University of Central Florida ( email )

PO Box 161400
Orlando, FL 32816
United States
407-823-0895 (Phone)

Gregory Noronha

University of Washington, Tacoma - Milgard School of Business ( email )

1900 Commerce Street
Campus Box 358420
Tacoma, WA 98402-3100
United States

Vijay Singal (Contact Author)

Virginia Tech ( email )

Blacksburg, VA 24061
United States
5402317750 (Phone)

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