We know this. This is related to an earlier post on the Limitations of Passive Index Investing.
A recent Research Affiliates article has looked into the cost of buying high and selling low by market indices and Index Funds.
Research Affiliates highlight that stocks added to market weighted indices are “routinely priced at a substantial premium to market valuation multiples (i.e., buying high), while discretionary deletions (excepting removals related to mergers, acquisitions, and other corporate actions) are routinely of deep-discount value stocks (i.e., selling low). In fact, additions tend to be priced at valuation multiples—using a blend of price-to-earnings (P/E), price-to-cash-flow (P/CF), price-to-book (P/B), price-to-sales (P/S), and (if available) price-to-dividends (P/D) ratios—that average over three times as expensive as those of deletions. This helps explain why from October 1989 through December 2017, the performance of additions lagged discretionary deletions by an average of over 2,200 basis points (bps) in the 12 months following the addition or deletion. Once investors recognize this buy-high/sell-low dynamic, they can avail themselves of some surprisingly simple ways to earn above-market returns”.
Obviously Index Fund providers understand this and may adjust their trading activities around additions and deletions from an index to minimise trading costs and impacts on performance.
A passive index solution is not passive, they are actively managed.
Nevertheless, there are costs around market index changes over time. These costs are incurred by the Index Funds, yet the costs are not evident given they are also included in market index returns.
Given Index Funds look to closely match market index returns (low tracking error) they incur these costs.
Based on the Research Affiliates analysis if Index Funds were to tolerate a higher level of tracking error they would add value above the index they are tracking by avoiding the longer term costs of market index changes. This is achieved largely by delaying changes to their portfolios.
Some serious thought needs to be given when appointing a passive index provider.
What are these costs?
The costs reflect that a stock outperforms over the period from the date it is announced it will be included in a market index until the effective date (when it is added to the market index).
Similarly, stocks removed from the market index underperform the market from the date of the announcement until effective date.
Research Affiliates estimates that additions outperform the market by 5.23% on average over the period between announcement date and effective date.
They also estimate that deletions underperformed the market by 4.29% on average over the period from announcement date to the day they are removed from the market index.
A total return different of 9.52%! (this analysis was undertaken over the period October 1989 to December 2017)
Research Affiliates also estimate that over one-third of the performance differential takes place on the day the Index makes the changes (e.g. adds the new stocks and makes the deletions).
As Research Affiliates says, the additions win big before they are added to the market index and deletions lose big before they’re dropped out.
Furthermore, once a stock is added to a market index, on average it underperforms the market over the next twelve months.
Likewise, a stock deleted from the market index will on average outperform the market over the next 12 months.
There is value to be added around market index changes and more broadly the rebalancing policy of an investment portfolio.
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