A Better Way to Index: Revisiting and Revising a Central Tenet of Index Methodology

Abstract

Most indexes are reconstituted periodically, typically quarterly or yearly, which induces high trading volume and significant trading costs for index funds. Here the authors propose a novel index reconstitution methodology that significantly reduces the trading volume and trading costs for funds tracking the index, without hurting the style purity of the index. The authors’ reconstitution methodology rebalances a small piece of the index every day, allowing index funds to use their daily cash flows to rebalance. Applying their reconstitution methodology to the Russell 2000, they find that the trading volume for funds tracking their proposed index is about 18% lower than that of funds tracking the current Russell 2000 Index. Further, funds tracking their index experience a 38% reduction in total trading costs, equivalent to 10 basis points of fund assets under management each year. Their methodology can be easily generalized and applied to most periodically reconstituted indexes and provides a solution to address the inefficiencies in current index methodologies.

TOPICS: Mutual fund performance, exchange-traded funds and applications

Key Findings

• • Indexes are reconstituted inefficiently, inflating transaction costs and reducing return for funds that track those indexes.

• • We propose a new index construction methodology that eliminates those inefficiencies and thus allows index mutual funds and ETFs to improve their returns without any sacrifice in style purity.

• • The improved returns from the use of this methodology are estimated to be substantial; for example, we estimate that a sample fund tracking the Russell 2000 Index using our new methodology would enjoy 10 bps of enhanced returns annually.