Investor Alert: Index Rebalancing Can Bring Hidden Costs

Index rebalancing is necessary to keep constituents in line with its stated mission. One of the unintended consequences, however, is that fund managers who follow these indexes must buy and sell these securities to mirror the changes during index reconstitution.

That causes the prices of securities added to indexes to rise temporarily, while values of securities deleted fall. Index providers spread trading over more days during quarterly reconstitution to mitigate the price pressure and minimize price spikes.

Yet two research papers by Dimensional Fund Advisors show that despite index providers’ steps to reduce the unintended effects of rebalancing, these pressures remain, both in the United States and internationally. These pressures have both short- and longer-term cost implications, hidden costs that don’t show up in annual expense ratios, the asset manager said.

Reconstitution brings hidden costs

Savina Rizova, co-chief investment officer and global head of research of Dimensional Fund Advisors, said that in the 20 days before index rebalancing, the average excess return is 4%, with a reversal of minus 5.7% in the next month in the U.S. In international indexes, the cumulative excess return is 3.5% in the timeframe before rebalancing, with a 1.9% reversal after.

Volume also spikes in those at the close during the reconstitution, Rizova said, spiking to 80 times higher in the U.S. and anywhere from 24 times to 130 times across international indexes.

These impacts are notable for people who buy or sell those individual names on those days and in the short term for index funds. However, Rizova said it matters for long-term investors as well.

“If you buy higher than you should, and you sell lower than you should, you're just leaving money on the table,” she said.

Dimensional estimates the cost for investors following S&P 500 indexes is equivalent to $226 million per year, although it did not have a cost estimate for international index funds.

As much as index providers have tried to mitigate the impact of rebalancing by lengthening the trading time, it’s difficult to find a solution because indexes follow strict rules, she said. With passive indexes still comprising the bulk of exchange-traded funds (ETFs), financial advisors should be aware of these lesser-known costs.

“Both of those research papers are part of our effort to just highlight that while indexing has a lot of benefits, like broad diversification, low costs, relative transparency and low turnover, it does come with some costs, and they are not just costs related to expense ratios,” Rizova said.