A recent academic paper claiming index rebalances significantly erode ETF returns over the long term has failed to consider the options ETF portfolio managers have to keep trading costs at a minimum, experts from across the ETF industry have warned.
The paper, titled Should Passive Investors Actively Manage Their Trades? and authored by Ph.D. candidate Sida Li of the University of Illinois, found US-listed passive equity ETFs face an average performance drag of 14.6 basis points (bps) a year due to inefficient index rebalances.
Li said in the five days between a transparent index announcing a reshuffle and enacting a rebalance, the stock prices of new index entrants rise by an average of 67 bps due to trading by frontrunners and hedge fund arbitraging activity. Subsequently, they fall by an average of 20 bps in the 20 days following a rebalance event, meaning those buying at market on close (MOC) on the final rebalancing day are subjecting themselves to a baked-in cycle of buying at the top of the market.
This dynamic is significant, Li argued, given ETFs tracking US equities averaged 16% portfolio turnover in 2020 which results in large portions of these ETFs’ holdings being hampered by the inefficiencies of “sunshine” trading.
More galling though is that actively managed ETFs avoid such costs. These more opaque products either adjust their baskets before or after rebalances are implemented – resulting in a saving of 7.3 bps a year versus sunshine traders – or they track non-public indices – creating a cost-saving of 9.6 bps.
Somewhat corroborating these findings, Timo Pfeiffer, chief markets officer at Solactive, told ETF Stream the firm had conducted similar research looking at just US large-cap indices – where one might expect transaction costs and turnover to be lower – and reached a performance impact of nine bps.
Pfeiffer added: “This of course depends on the year but in terms of the number they came to, this was no surprise to us because our results were similar.”
However, he did not agree with how the research portrayed passives as purely sunshine traders with no flexibility to spread trades out over time.
“They can execute through an investment bank and get a guaranteed execution on close, so there are many flexibilities in reality and ways to take into account liquidity, size, trades coming up, or market moves,” he continued. “These are attributed purely to active ETFs in the research but also passive ETFs can and are doing similar types of judgements and similar types of trades.
“Passives do not have to mindlessly follow the rules if there is something that obviously does not make sense in such a rebalancing. They can act about it and spread it over time. If passive ETFs are passive, why do they have portfolio managers? Why do Amundi, Lyxor and DWS have trading desks? They can still act smartly.”
Offering an ETF issuer’s perspective, Brett Pybus, head of iShares EMEA investment and product strategy at BlackRock, explained the firm actively looks to maintain tight index tracking, minimise market impact and keep trading costs down during index changes.
“We employ a number of strategies to meet these objectives that may involve trading during the continuous trading day – for example, away from the close – in advance of, on or after the rebalance effective date,” Pybus said.
Agreeing, a spokesperson from Vanguard told ETF Stream: “Many index funds will attempt to preserve shareholder value when rebalancing due to an index change, which often means trading before or after the effective date of an index change.
“This can benefit fund investors by reducing transaction costs or associated market impact of the fund’s trading. Index fund managers will weigh the potential transaction cost savings against the risk of an increase in tracking error to determine an optimal trading strategy around an index change.”
Aside from manually trading before or after MOC on the final rebalancing day, there are other mitigating steps ETF issuers can take to reduce rebalancing costs.
In the research, Li referred to the Center for Research in Securities Prices (CRSP) indices that Vanguard uses, which break down a benchmark into 20% increments and rebalance one per day over five trading days to soften the impact of arbitraging activity.
Another route is to track indices with lower turnover rates, Li said. For instance, the S&P 500’s portfolio turnover is just a tenth of the 52% turnover for the S&P SmallCap 600 Growth index in 2021, meaning the large-cap benchmark is far less exposed to the costs associated with rebalancing transactions.
However, Li does not account for some of the other tools deployed by large managers to soften rebalancing costs. Vanguard, for example, has the majority of its US ETF assets (including passive) in multi-share class index ETFs, meaning they are a share class of their equivalent mutual fund and are exempt from having to disclose their holdings daily.
Herb Blank, senior consultant at Global Finesse, added Vanguard also uses stock loans, partakes in syndicate share offerings and tactically deploys derivatives to counteract the impact of execution costs.
There are also some qualities inherent to transparent ETFs that opaque ETFs miss out on, BlackRock’s Pybus argued. He said BlackRock’s internal analysis indicated any returns lost during rebalances are “largely compensated for” in the tighter spreads enjoyed by transparent ETFs which points to a difference in the cost of transacting the ETFs themselves.
“Transparency allows both retail and institutional investors to see the exact composition and weightings of the funds they hold on a daily basis,” Pybus continued. “It also allows all market participants to easily detect the existence – and estimate the extent of – any discrepancy between the value of an ETF’s portfolio and the current exchange price of the ETF’s shares, which leads to a more efficient arbitrage mechanism and secondary market trading.”
Reflecting on Li’s research, Global Finesse’s Blank praised the fact a draft paper by a Ph.D. student with no professor as co-author has still managed to garner international attention and spark controversy.
“The main point of the study is that major rebalancing trades of passive portfolios should be actively managed to mitigate front-running caused by before-the-fact transparency,” Blank said.
Making a call to managers still using the ‘legacy’ method for rebalances, he concluded: “As part of their fiduciary responsibilities, portfolio managers need to get more active and modern in their trading methods to protect their investors from avoidable impact costs.”
Another call to action came from Solactive’s Pfeiffer, who has lobbied the world’s largest index providers to cooperate and spread out the rebalances of their overlapping benchmarks – such as their global indices – across the calendar so one benchmark rebalances each month throughout the year.
“Our research shows doing this diminishes the cost impact of rebalancing – it is still there but significantly less when spread out across the calendar. The solution is to spread rebalances across different dates.”