On the hidden costs of passive investing

TL;DR

This paper reveals that passive investing strategies can incur significant hidden costs due to timing of trades around index reconstitutions, and proposes that proactive liquidity provision can generate substantial profits.

Contribution

It demonstrates the existence of hidden costs in passive investing and shows how strategic pre-emptive trading can lead to consistent profits.

Findings

Waiting until market close for reconstitution incurs hundreds of basis points in costs.

Gradual pre-emptive acquisition reduces tracking error and costs.

Liquidity provision at reconstitution can yield hundreds of basis points in profit.

Abstract

Passive investing has gained immense popularity due to its low fees and the perceived simplicity of focusing on zero tracking error, rather than security selection. However, our analysis shows that the passive (zero tracking error) approach of waiting until the market close on the day of index reconstitution to purchase a stock (that was announced days earlier as an upcoming addition) results in costs amounting to hundreds of basis points compared to strategies that involve gradually acquiring a small portion of the required shares in advance with minimal additional tracking errors. In addition, we show that under all scenarios analyzed, a trader who builds a small inventory post-announcement and provides liquidity at the reconstitution event can consistently earn several hundreds of basis points in profit and often much more, assuming minimal risk.