Nothing is perfect. While passive investment products such as ETFs and Index Funds are gaining favour with investors, it should be noted that there are some cons to go with the pros of indexing. One in particular is that indexers suffer from the index reconstitution effect.
Indices are not entirely static. Their constituent stocks change from time to time based on the index providers parameters or committee’s discretion. For example, let’s say that the Dow adds a company to the Dow Jones Industrial Average. They make the announcement on January 1 and then set the effective date to be January 10. Since there are significant dollars invested in index funds that track the Dow, the market knows that there will be massive buying pressure on the stock to be added come January 10 (the main goal of index funds is to minimize tracking error). Liquidity providers will be buying up this company between the announcement date and the effective date to make sure that all the index funds can purchase this stock as necessary.
The Index Fund Investor Loses Out
The liquidity providers, in buying up the stock to provide liquidity on the effective date, generally run up the price of these stocks so they form part of the index funds at potentially artificially high prices. A double whammy is that the price of the stock then tends to drop back down to the pre-announcement date price, but only after it has been included in the index fund. So what does this mean for the index fund investor? They are potentially losing out on some returns by paying for the costs of liquidity that are required by index funds that strive to minimize tracking error.
I don’t have the reference papers in front of me to cite and I’m due on the couch to watch a movie with Fiona, so I’ll have to dig up some references later… sorry! You’ll have to take my word for now that this phenomenon exists reliably.