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Index Investing - the hidden costs

Selecting an index strategy - the top 8 recent papers

The last few years have witnessed significant growth in index investing by institutional investors, seeking to benefit from high transparency, low turnover, and low costs.

For institutional investors considering an index strategy, it is important to be aware of the "hidden costs" of index investing and to be confident that these are well-managed by the index or fund provider. A FTSE Russell paper in the list below provides valuable insight into the process of index reconstitution.

We have curated a list of eight recent papers, which review the rise of index investing, examine the costs, document the performance through market cycles, and show how to calculate the probability that active or passive strategies will outperform.

hidden animal index

The Cost of Tracking an Index (Dimensional, 2016)
Indices were created as a simple tool used by investors to evaluate the performance of a manager on a risk-adjusted basis. The role of indices evolved with the introduction of index funds. But are the indices exact representations of the underlying asset class? If not, then incurring the costs required to track them perfectly may not be required.

Russell index reconstitution – minimising the costs associated with index turnover (FTSE Russell, 2016)
For passive investors, index reconstitution is not merely an academic topic. Index rebalancing, if poorly designed or implemented, will represent a hidden cost to index investors, so the process of index reconstitution is key. FTSE Russell explains how a well-designed process can benefit investors.

The Rise of Indices Is Changing the Face of Investing (S&P Dow Jones, 2016)
A confluence of factors including technology, regulation, investor skepticism of manager skill, and fee-consciousness, has favored the rise of index investing. In this report, the authors provide an overview of the rise of indexing, and its impact on the asset management industry.

Passive versus Active Fund Performance: Do Index Funds Have Skill? (Crane and Crotty, 2016)
We apply methods designed to measure mutual fund skill to a cross-section of funds that should not exhibit managerial portfolio selection skill: index funds. Surprisingly, these tests imply index fund skill exists, is persistent, and is in similar proportion as in active funds.

Active versus Passive - Version 5.0: Thoughts on How You Can Get on Base (2016)
This paper by Segal Rogerscasey examines the ongoing debate between active and passive management, highlighting the pros and cons of both strategies. How can institutional investors calculate the probability that active or passive strategies will outperform, and how do they decide which approach is best for their situation? 

The case for low-cost index-fund investing (Vanguard, 2016)
The authors analyse how indexing performs in a variety of market cycles and time periods, and provide pointers for investors to consider when assessing different strategies. The paper describes why index investing is expected to continue to be successful over the long term.

Performance Attribution for Passive Strategies (State Street, 2016)
This white paper reviews the growth of passive and active investing. The authors discuss the trends that have been driving each approach and the factors essential to performance attribution in a passive investment strategy. The aim is to assist managers spot a successful performance strategy that gives the right level of insight and transparency into key passive performance drivers.

The Dirty Little Secret of Passive Investing (Research Affiliates, 2016)
Passive investments have a dirty little secret: their returns are materially depressed by implicit implementation costs. You won’t see these costs in performance attribution, unbundled management fees, or standard trading cost analyses. But they should be taken into account when selecting an index strategy. In particular, the implementation of popular cap-based indices is not costless; indeed, their implicit trading costs are often higher than that of well-designed smart-beta offerings.

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