Beware the Hidden Costs of Indexing
Imagine ringing in the new year in New York City’s Times Square with a million of your closest friends. Shortly after the ball drops, everyone is ready to leave—at the same time. Demand for a ride in that area soars, and so does the price for the suddenly coveted service. This dynamic surge is a lot like the index reconstitution effect, an important yet less-visible source of costs associated with index investing.
Index funds seek to mirror the performance of an index. To do that, they need to mirror the changes in the index’s holdings at the time of its reconstitution, when stocks are added to or dropped from the index. This lack of flexibility can lead to increased trading volume and price pressure around that reconstitution, the so-called index reconstitution effect.
Robert J. Pyle, CFP®, CFA, AEP® founded Diversified Asset Management, Inc., in 1996 to provide personalized, comprehensive wealth management services to successful individuals, families, single women, and business owners. His specialty is addressing the complex financial needs of self-employed professionals, corporate executives, and small-business owners. Our disclosure can be found here. The views, opinion, information, and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc. Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting, or tax advice.