Bridge over ocean
1 July 2006 Financial Analysts Journal Volume 62, Issue 4

Index Changes and Losses to Index Fund Investors

  1. Honghui Chen
  2. Gregory Noronha, PhD, CFA
  3. Vijay Singal, CFA

Because of arbitrage around the time of index changes, investors in funds linked to the S&P 500 Index and the Russell 2000 Index lose between $1.0 billion and $2.1 billion a year for the two indices combined. The losses can be higher if benchmarked assets are considered, the pre-reconstitution period is lengthened, or involuntary deletions are taken into account. The losses are an unexpected consequence of the evaluation of index fund managers on the basis of tracking error. Minimization of tracking error, coupled with the predictability and/or pre-announcement of index changes, creates the opportunity for a wealth transfer from index fund investors to arbitrageurs.

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