Index trackers offer investors a cheap way to gain exposure to stocks markets. But with estimates putting the value of assets recreating the S&P 500 at over 10% of total index capitalisation, investing in an S&P 500 tracker is akin to buying a US$1.5 trillion managed equity portfolio [6]. In this study, we analyse the S&P 500, the most prominent market-cap-weighted index in the world, and estimate a hidden turnover cost of about 20 basis points per year.
When stocks enter and exit the index, index-tracking fund managers attempt to trade as much as 10% of an entire company, with their intentions publicly known in advance. This opens up the possibility of other market participants profiting at their expense, creating an additional cost for passive investors that is not reflected in tracking error.
Standard and Poor’s (S&P) determine the rules governing the composition of the S&P 500, which amount to a trading system for an index-tracking fund. Since October 1989, S&P announce changes in the composition of their index early enough to allow index fund managers to buy (or sell) stocks added to (or removed from) the index in a timely fashion.
For equity investors, the costs associated with turnover can be split into two: 1) commissions that are paid for brokerage services; and 2) market impact, often referred to as “slippage”, which forces investors buying large blocks of shares to pay a premium. We focus on the latter as commissions are very low; even assuming a high rate of 10 basis points per transaction, the resulting cost is less than 2 basis points per year.
We start by detailing the data we use for this analysis and how it was collected. We then analyse S&P 500 turnover since 1989, and estimate the commissions paid, before estimating the price impact of changes to index constituents.