The Hidden Costs of Passive Investing

The idea that capitalization-based indexes are costless is “lunacy,” according to Research Affiliates.

Passive investments may not be quite as cheap as they appear.

According to a report by Research Affiliates, the gross returns of index investments are “materially depressed” by hidden trading costs.

“You don’t see these costs in performance attributions, unbundled management fees, or even standard trading costs analyses,” wrote Research Affiliates Director Michael Aked. “The fact that they are unobserved doesn’t mean that they don’t exist, can’t be measured, or shouldn’t be taken into account when selecting an index strategy.”

These hidden costs are implicit trading costs, or the “loss of performance due to transactions occurring at prices that would not have prevailed if investors didn’t need to enter trades.” When a stock becomes a member of an index, investors pay a “substantial” premium.

“An index is just a model portfolio, and it cannot be implemented above and apart from the laws of managing money,” Aked wrote. “To attract sellers for stocks you wish to buy, you have to pay more. To attract buyers of stocks you wish to sell, you need to ask for less.”

These price differentials add up so that the cost of implementing capitalization-based indexes is “meaningfully higher” than that of well-designed smart-beta offerings, he continued.

Furthermore, Aked argued that this costly construction of indexes can mean they are essentially active management.

“Index designs run the full gamut, from highly systematic, rules-based procedures to largely discretionary, committee-based processes,” he wrote. “In every case, the explicit selection criteria, weighting rules, and committee decisions directly affect indexes’ active shares.”

While trading costs can be expensive, cap-weighted indexes are self-adjusted, meaning they minimize that particular type of cost, Aked noted. However, he continued, that does not mean they should be viewed as costless.

“It’s lunacy to believe that the implementation of popular capitalization-based indexes is costless, that their negative selection and weighting bias is zero, or that their implicit trading cost as a percentage of aggregate assets is currently below that of well-designed smart-beta offerings,” he concluded.

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