30 October 2015 - 4 minute read

Investors often buy index trackers to gain low-cost exposure to “the market”. These strategies have low turnover, but can suffer high slippage costs because they buy and sell index constituents inefficiently. By analysing the price impact of additions and deletions to the MSCI World Index, we find hidden costs of around 10 basis points per year for the naïve index tracker, echoing our earlier findings for the S&P 500.

Over the past 25 years, we have seen an influx of money into the “passive” tracking of market-capitalisation-weighted indexes. Approximately US$2.2 trillion is tracking the S&P 500, or almost 12% of the index’s total capitalisation. Thus, when a company is added or removed from the index, trackers need to buy or sell more than 10% of the entire company over just a few days.

Index changes are also typically announced the week before, making it possible for other market participants to profit at the trackers’ expense. In earlier Winton Research, we estimated that this predictable trading behaviour cost at least 20 basis points (bps) per year for those tracking the S&P 500 between 1990 and 2011 [1]. Here we update this analysis to 2015 and extend it to the global MSCI World Index [2].

Price impact analysis

We focus on index additions and deletions that require a tracker to actively purchase (sell) the added (dropped) stock. We then consider the average price move as a function of “event time”, which is defined as 0.0 when the announcement of a change to the index is made, and 1.0 when the change occurs.

Results are shown in Figure 1, and we see that there was an average price move of at least 3% as the stock enters or exits an index. The impact of index trackers purchasing or selling the stock is the obvious culprit for this price move, although there may also be some underlying momentum in the stock price for these events.

Figure 1. Average excess price move for additions and deletions in event time for S&P 500 and MSCI World indices, 2002-2015

Bands show 1 standard error.

Profiting from the effect

To estimate the potential cost to the naïve index tracker, we construct improved index tracking strategies that benefit from the effects seen in Figure 1, albeit with a higher tracking error.

For example, a tracker could buy a stock due for addition at the first possible close after the announcement, sell on the day it enters the index, and buy it back a few days later. This is the approach taken by our “basic arbitraging tracker strategy”.

A tracker could further enhance their strategy by buying on the day the change is announced, or even buying before the announcement is made by anticipating the changes. The latter is possible when the index methodology is fairly transparent, as is the case for the MSCI World. For our “advanced arbitraging tracker strategy”, we assume the tracker anticipates changes five days ahead of announcement with a 70% success rate [3].

Both arbitraging strategies hold the stock until they sell at the close of the addition day, and then buy back the stock at a later date [4]. The reverse process is used for deletion events. The performance of these strategies, relative to that of the naïve index tracker, is shown in Figure 2.

Figure 2. Cumulative outperformance of arbitraging tracker strategies

Cumulative outperformance of arbitraging tracker strategies that take advantage of the price impact of index additions and deletions. Due to lack of daily returns data pre-2001 and inconsistency in index additions and deletions data pre-2002, MSCI World Index results start in 2002.

Both arbitraging strategies are successful, achieving average outperformance of around 10 bps a year versus naïve index trackers since 2002. These profits can only be made at the naïve index tracker’s expense.

Should we expect such similar levels of hidden costs for the two indices? The average weight of stocks entering and exiting the S&P 500 is around seven times larger than the weight of those entering and exiting the MSCI World. There are, however, more than six times as many additions and deletions for the MSCI World. As a result, the turnover generated in both indices ends up being fairly similar. This, combined with the similar price impact in Figure 1, might explains why the comparable costs.

One interesting feature of the data is the apparent decline in the profitability of the arbitraging tracker strategies, with estimated excess returns exceeding 20 bps a year before 2002, and only 10 bps since 2002. Part of this decline can be attributed to a lower turnover of the indices, but most of the change is due to a smaller price impact. Such changes demonstrate the ever-changing human nature of the financial markets, as participants adapt their behaviour.

Conclusion

We observe a price impact of tracking both the S&P 500 and MSCI World indices, with an expected move of at least 3% for an individual stock, when it enters or exits the index. The exact cost to the index investor has changed through time. But, with recent estimates of around 10 bps per annum, it is not to be ignored. An active manager could have a significantly higher turnover than an index tracker, before incurring the same level of costs.    


References

[1] Winton Research, Hidden Costs in Index Tracking, January 2014.

[2] Methodological details are broadly similar to those in the earlier research.

[3] We have approximated how the arbitrager with a 70% success rate would perform by simulating the returns of a strategy that had perfect foresight, and multiplying these by 0.7.

[4] The number of days between the addition date and when the stock is repurchased is the same as between the initial buying of the stock and the addition date.

This article contains simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading.  Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity and cannot completely account for the impact of financial risk in actual trading.  There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any investment will or is likely to achieve profits or losses similar to those being shown.

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