Investors are paying "significantly" higher turnover costs due to index arbitrageurs taking up opposite positions at the point when an index rebalances, according to research conducted by Solactive.
The white paper, entitled (The Hidden) Index Turnover Costs: The Visible Price of Transparency, said due to the rules-based nature of indices and the fact rebalancing days are highlighted in advance, index arbitrageurs can anticipate these changes in indices.
Arbitrageurs can bid up, or down, the price of stocks which are either being added or removed from an index meaning investors in the index pay more when the rebalancing takes place, it said.
Therefore, this leaves investors with an implicit cost causing a drag on performance, which may not have been anticipated when investing in the product.
Using a eurozone blue-chip index, the research found that the average turnover cost across 10,000 rebalancing simulations ranged between 0.12% and 0.36%.
"An index composition is adjusted by buying and selling stocks when certain components are added or removed from a certain index at the specific rebalancing days," said Timo Pfeiffer, head of research and business development at Solactive, a Frankfurt-based provider of index investments.
"This adjustment allows index arbitrageurs to anticipate changes beforehand and take opposite positions as the index composition is generally rule based.
"There are implicit costs associated with index adjustments that can make investments into indices costlier than an investor might anticipate beforehand," he added.
In order to "drastically" reduce these costs, Pfeiffer said there were a number of industry changes which needed to occur.
The first, he said, was to have more competition between index providers. This would lead to different rebalancing cycles for similar indices meaning the price impact of each trade would be reduced as they would be spread out.
The report added transparency was needed "with a clear announcement" of the changes that would take place in the rebalancing in order to "dilute" the impact of on stock prices.
It said: "A transparent rebalancing procedure with a clear announcement well before rebalancing can help expand the time when the index arbitrageurs make their trades... and dilute the impact on the turnover costs."
"Turnover costs are significantly larger than zero," Pfeiffer added.
"Taking into account these considerations, we believe that the implicit costs that investors face when investing into index tracking products can be significantly reduced, if not eliminated."
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