Some passive index funds and ETFs that attract investors with increasingly low fees may come with a hidden cost based on buying stocks at higher values and selling them at lower ones.
The potential shortcomings for financial advisors and clients who embrace low expense ratios and passive products have been highlighted in recent studies. In the latest example, a research paper released by Dimensional Fund Advisors late last year explored the pricing impact on international stock indices from rebalancing transactions. These movements to substitute one company for another that has grown larger carry ramifications to ETFs and other funds, since they must avoid so-called tracking errors by changing their holdings to reflect this reconstitution.
READ MORE: Portfolio rebalancing comes with $16B price tag, study finds
Between 2014 and 2023 on the FTSE 100, S&P/TSX 60, S&P/ASX 300, EURO STOXX 50 and Nikkei 225, the stocks entering the five international indices carried “positive excess return patterns, and deletions exhibit negative excess return patterns before reconstitutions, while both exhibit reversals after reconstitutions,” Dimensional’s study found. The company’s analysis of U.S. equity indices last year reached similar conclusions. The findings call for “looking past that headline expense ratio number” to get the “true cost of ownership,” said Kaitlin Hendrix, Dimensional’s asset allocation research director and lead author of both studies.
“All of these costs can add up, but they can be hard to identify,” she said, referring to factors such as reconstitution and other elements that affect indices and funds tied to them, such as securities lending revenue, drifting from the stated strategy or other corporate actions. “We know that those rigidities, that lack of flexibility, are going to come with a cost. … Just the fact that it’s an index fund doesn’t mean you don’t have to do due diligence on the index and on the fund provider itself.”
The research followed other studies exploring the rebalancing of index funds, such as an academic working paper posted last month that found they “incur adverse selection costs,” meaning that their approach “effectively buys at high prices and sells at low prices.”
For advisors and their clients, the simple answer points to purchasing a total stock market ETF or fund, according to planner Allan Roth, the founder of Colorado Springs, Colorado-based Wealth Logic and a prolific investment strategy columnist. He explained the reconstitution problem in a 2010 column that he said drew a handwritten letter from the late Vanguard founder Jack Bogle.
