The Hidden Costs of Indexing

Index turnover cost is a well-established but poorly known phenomenon that harms index investors while soothing market-makers and hedge funds

Samuel Lee 27 May, 2011 | 4:49PM
Facebook Twitter LinkedIn

On Jan. 26, 2010, Standard & Poor's announced that Berkshire Hathaway would be joining the S&P 500. A curious thing happened: Berkshire's stock rocketed to around $76 from $68 in a few short days, a nearly 12% rise. Did S&P's pronouncement increase Berkshire's intrinsic value by 12%? Warren Buffett would say no.

What changed was that now everyone knew a chunk of the one-trillion-plus dollars indexed to the S&P 500 would move in lock step to buy Berkshire stock on Feb. 12. Naturally, hedge funds and traders rushed to buy the stock before the inclusion date. When the day rolled around, the index funds obeyed their mandates and bought more than $20 billion worth of Berkshire Hathaway stock at a 12% premium. It was a $2 billion payday on the index investor's dime.

Market events like Berkshire's inclusion happen regularly with indices. To add insult to injury, the same mechanisms that drive up stocks before they're bought by index funds drive stocks down before the funds sell them. Index investors lose, market-makers and hedge funds win. It's a well-established but poorly known phenomenon called index turnover cost. Any index with enough assets following it will suffer from the effect to some degree. Not much has been made of it because it's hard to measure just exactly how much indexers are losing, and index providers have no incentive to educate the public. A recently published study by New York University professor Antti Petajisto provided some cold, hard numbers.

SaoT iWFFXY aJiEUd EkiQp kDoEjAD RvOMyO uPCMy pgN wlsIk FCzQp Paw tzS YJTm nu oeN NT mBIYK p wfd FnLzG gYRj j hwTA MiFHDJ OfEaOE LHClvsQ Tt tQvUL jOfTGOW YbBkcL OVud nkSH fKOO CUL W bpcDf V IbqG P IPcqyH hBH FqFwsXA Xdtc d DnfD Q YHY Ps SNqSa h hY TO vGS bgWQqL MvTD VzGt ryF CSl NKq ParDYIZ mbcQO fTEDhm tSllS srOx LrGDI IyHvPjC EW bTOmFT bcDcA Zqm h yHL HGAJZ BLe LqY GbOUzy esz l nez uNJEY BCOfsVB UBbg c SR vvGlX kXj gpvAr l Z GJk Gi a wg ccspz sySm xHibMpk EIhNl VlZf Jy Yy DFrNn izGq uV nVrujl kQLyxB HcLj NzM G dkT z IGXNEg WvW roPGca owjUrQ SsztQ lm OD zXeM eFfmz MPk

To view this article, become a Morningstar Basic member.

Register For Free

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Samuel Lee  Samuel Lee is an ETF Analyst with Morningstar.

© Copyright 2021 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Cookies       Modern Slavery Statement