Index Funds and the Liquidity Premium

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.

Index Reconstitution

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.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 7 comments
  • Jordan Clark

    I’ve read and you told me about Dimensional Fund’s have a trading advantage because they buy and sell shares more slowly to avoid this problem. But that makes me wonder, are Dimensional Funds still traded automatically by a computer like most indexes or does an active money manager / trader actually buy and sell the shares to meet their desired targets as they see the best opportunity? Is there a slight bit of active management in there?

    Thanks, Jordan

  • Preet

    @Jordan – Dimensional has professional traders at the helm, yes. They also have portfolio managers too. It was explained to me that if a PM has $50MM to invest, he/she will write up orders for $100MM and tell the traders to execute the best $50MM in trades. There’s more to it than that, but if you look at tracking error of DFA funds they can be high, but DFA doesn’t care.

  • Jordan Clark

    Do you think that as indexing becomes more popular (particularly standard cap weighted indexes) that they will become less effective because of this liquidity premium?

  • Preet

    It will certainly have an effect. There is an equilibrium between indexing and active management, and currently (and probably for the foreseeable future) indexing will win *on average*. As more and more people index, the less efficient the marketplace becomes and eventually a point would be reached where active management can reliably provide value. We probably won’t have to worry too much about that in our lifetime though. Keep in mind the most popular cap weighted indices tend to be the most broad and the liquidity of those underlying stocks is pretty good. So the effects will be there, but will be more prevalent for index funds that track the more exotic asset classes (read less liquid). For a broad indexer, it’s a nuisance, but probably not cause for abandoning the strategy of indexing.

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