Index Reconstitution: The Price of Tracking

by Sergio Mariaca on Jun 2, 2016 9:03:11 AM |Share:

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Index funds are an innovative solution for investors that provide diversified investments at low fees. On any given day, an investor can observe the performance of indices from providers such as MSCI,1 S&P,2 or Russell3—and that means it’s easy to monitor whether or not an index fund manager replicated the index’s performance (gross of fees and expenses). However, an index fund manager’s strict adherence to an index comes at a cost in the form of reduced discretion around trading.

Most indices revise their list of index constituents periodically (e.g., annually or quarterly), at which time securities may be added or deleted from the index. This process is commonly referred to as index reconstitution. For example, the annual reconstitution of the widely tracked Russell indices will occur on June 24, 2016. Russell index fund managers will need to buy additions and sell deletions for the indices they track in order to minimize tracking error4 relative to the index. Any deviation of the fund from the index, over days or even hours, could result in different returns from the index.

Exhibit 1: Equal-Weighted Average Trade Volume for Index Additions and Deletions


S&P data provided by StanS&P data provided by Standard & Poor’s Index Services Group. Russell data © Russell Investment Group 1995-2016, all rights reserved.


MSCI data © MSCI 2016, all rights reserved.

The effect on volume from index rebalance trades is apparent in a huge volume spike on trade reconstitution day. Exhibit 1 illustrates average trade volume for additions and deletions in four major indices during the 80-day period surrounding reconstitution. Each of the charts shows a marked increase in trade volume on the effective date of reconstitution relative to the surrounding days. The effect is pervasive across the market capitalization spectrum as well as geographic region.

For each index, this large liquidity demand tends to drive up the prices of securities with greater purchase demand (generally additions to the index) relative to the other securities in the index. It also tends to push down prices of securities with greater sell demand (generally deletions from the index) relative to the other securities in the index. Thus, for an index being tracked by a large amount of assets, the index has generally added securities at higher prices and deleted securities at lower prices than it would have if no assets had been tracking it. This phenomenon is the result of index managers’ demanding liquidity on or around the index reconstitution date.

Exhibit 2: Effect of Delaying Reconstitution Month


After the reconstitution of an index, as the liquidity demands of index managers decline, research shows this price effect tends to reverse. That is, additions tend to underperform the index while deletions tend to outperform. As a result, index managers’ implicit trading costs can result in a performance drag on the index and, consequently, funds tracking the index.

A simple experiment in delaying reconstitution allows us to estimate how much this price pressure has impacted index performance. Exhibit 2 compares average monthly returns for two sets of Russell indices; one set is rebalanced on the June-end reconstitution date and the other three months later. As shown in the final three columns, delaying rebalancing improved average returns between 0.15% and 0.73% per month from July through September—the three months between the rebalance date of the standard indices and their delayed counterparts. For all calendar months, including October through June when holdings are identical for both rebalancing methods, this amounts to a performance benefit ranging from 0.04% to 0.18% per month, or approximately 0.45% to 2.21% per year.


Index funds may be a good option for investors seeking investments with low fees. However, in an attempt to match the returns of an index, an index fund manager sacrifices trading flexibility. Because of high liquidity demands around index reconstitution dates, index funds may incur high trading costs that do not appear in expense ratios but do affect net returns. The funds’ goal of minimizing tracking error may come at the expense of returns. Investors should consider the total costs, both in terms of expense ratio and trading costs, when evaluating investment options.

Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

There is no guarantee an investing strategy will be successful.

1.Morgan Stanley Capital International.

2.Standard & Poor’s Index Services Group.

3. FTSE Russell is wholly owned by London Stock Exchange Group.

4. Tracking error is the standard deviation of the return differences between a fund and its benchmark.

What is Fiduciary Advice?

by Sergio Mariaca on May 17, 2016 4:17:46 PM |Share:

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Anyone searching for investment advice is undoubtedly confronted with many choices of service providers operating under titles such as certified financial planner, financial consultant, registered investment advisor, stockbroker, and insurance agent.

These titles can be confusing because on the surface it is not clear whether these professionals are legally required to have a client’s best interest in mind when making investment recommendations.

Many investors may have read that the Department of Labor (DOL) announced a substantial overhaul in the regulation of financial advice given on retirement savings. Central to this discussion are two terms: fiduciary and suitability. What does it mean for an advisor to operate on a fiduciary standard, and how does this differ from a suitability standard?

The Fiduciary Standard

The DOL has described a “fiduciary” as someone who is required to put their clients’ best interest before their own profits. Fiduciaries include registered investment advisors, advisors to mutual funds (like Dimensional), and others who hold themselves out to be fiduciaries (like trustees and certain retirement plan consultants).

Fiduciaries are required to act impartially and provide advice that is in their clients’ best interest, and in doing so, must act with the care, skill, prudence, and diligence that a prudent person would exercise based on the current circumstances. A fiduciary must avoid misleading statements about fees and must avoid conflicts of interest.

Fiduciaries are typically compensated by payment of a fee rather than a commission. Fiduciaries to retirement plans, plan participants, and IRAs are also prohibited from receiving payments that create conflicts of interest unless they comply with the terms of certain exemptions issued by the DOL.

Probably most importantly, clients can expect that a fiduciary will act with transparency and avoid prohibited conflicts of interest. For example, given two comparable investment choices for a client, a fiduciary should typically recommend an option with lower management fees.

Fiduciaries are personally liable for breaches of their fiduciary duties. For example, if there is a loss caused by a breach of fiduciary duty, the fiduciary must make the plan or IRA whole by restoring any losses caused by the breach and restoring to the plan or IRA any profits made through the use of plan or IRA assets. Civil actions to obtain appropriate relief for a breach of fiduciary duty may be brought by a participant, beneficiary, fiduciary, or the US Secretary of Labor, and the fiduciary may be subject to excise tax penalties.

The Suitability Standard

Historically, representatives of a broker-dealer are required under the securities laws to judge the suitability of a product for a prospective investor, based primarily on that person’s financial goals, income, and age. Unless agreed otherwise, under this standard the rules do not legally require a recommendation of the most cost-effective product, a disclosure regarding conflicts associated with the investment, or disclosure of the compensation received when making that recommendation. Under the new DOL rule, it may mean that common forms of broker compensation, such as commissions and revenue sharing, will be restricted.

A Single Standard of Advice

As many financial advisors are dual registered as both brokers and investment advisors, it can be difficult to determine under which standard investment advice is given. A primary goal of the recent regulatory changes was to create a single standard for retirement financial advice based on a fiduciary model. Many clients already receive fiduciary advice, and for those clients the change in rules will not have much impact. Following the new DOL rule, it may be the case that professional financial advice for retirement assets (whatever the source) is subject to a level fiduciary standard.1 However, as with any investment advice, clients should conduct their own research, ask questions, and learn more about the reputation and philosophy of an advisor.

  1. Note that in certain circumstances, information provided by advisors or brokers may not be treated as fiduciary advice. Some examples of these exceptions from the new DOL rule are providing general investment education, simple “order-taking” (executing an order to buy or sell without providing a recommendation), or certain “robo-advice.”
  2. For informational purposes only and not for the purpose of providing tax or legal advice. You should contact your tax advisor or attorney to obtain advice with respect to any particular issue or problem.


Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

This information should not be misconstrued or otherwise interpreted as legal advice. Please consult with qualified legal or tax professionals regarding your individual circumstances.



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