The Hidden Costs of Index Rebalancing

Abstract

Periodic index rebalancing is associated with substantial price movements for the stocks added to and deleted from the index. These price changes represent significant hidden costs to portfolio managers who track the index. This article examines this issue, focusing on the dramatic return movements associated with the change of the S&P 500 index com-position on July 19, 2002, when seven non-U.S.companies were replaced by seven U.S. companies. We examine the liquidity and return patterns in these 14 stocks following the announcement date on July 9, 2002. We show that by adopting a trading strategy that spreads out trades in the period before the reconstitution date, trading costs can be dra-matically reduced without bearing significant tracking error risk. These differences can significantly improve the net performance of investment funds. More generally, these results indicate that trading strategies that provide guaranteed market-on-close prices have hidden costs to investment-managers.