Minimizing Index Rebalancing Costs in Passive Funds Can Improve Returns

Strategic approaches to rebalancing can minimize passive funds’ trading costs, which are usually passed on to investors.

The CFA Institute summarized a study done by a team from Research Affiliates that experimented with various rebalancing strategies to reduce trading costs and enhance returns in index funds. They noted that stocks added to traditional market-capitalization-weighted indexes tend to be overpriced due to recent momentum, while those removed tend to be undervalued with poor momentum.

Studying the returns of the S&P 500 index between October 1989 and June 2021, the researchers found that over the 12 months following rebalancing, the dropped stocks outperformed the added ones by an average of 22%. During the 12 months leading up to the index changes, new additions outperformed the market by 41.5%, while deleted stocks underperformed by 29.1%, resulting in a 70.6% performance gap. The 12-month post-index-rebalancing performance was attributed to the announcement effect, the liquidity effect and the mean-revision effect.

Based on simulated indexes of the S&P 500 that used different dates for rebalancing, the researchers found delaying trades by three months resulted in outperformance of 13 basis points (bps) compared to the S&P 500, and delaying trades by 12 months resulted in 23 bps of outperformance. Trading on the day after an addition or deletion announcement led to outperformance of 12 bps.

The researchers concluded that passive funds following indexes can provide better returns for investors if they change the way they add and drop stocks.

Source: “Earning Alpha by Avoiding the Index Rebalancing Crowd,” by Cathy Scott; CFA Institute, In Practice, May 2023.