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ETFs lose their balance

“Hidden costs” are two words that you would rather not hear – but sometimes they do emerge. It’s an issue that came up a few years ago when the Mifid II regulations forced active funds to disclose the (sometimes hefty) transaction costs they were incurring, detracting from the end investor’s gains.

Now it seems a secret price is also being paid in parts of the passive fund arena. “Should passive investors actively manage their trades?”, a research paper published late last year, has caused quite a stir by pointing out additional costs racked up by certain exchange traded funds (ETFs). The paper’s author, Sida Li, found that a sample of ETFs tracking mainstream equity indices that pre-announce when they rebalance their constituents have been generating some hefty extra costs – or at least detracting from gains.

The problem here relates to the fact that the index rebalances are announced a few days in advance but the ETFs only change their portfolios just before those changes come into force. That means that what the paper describes as “opportunistic traders” can buy the relevant shares ahead of time and sell them on when the ETF actually rebalances. This behaviour has had a distorting effect on prices: the paper found that in the case of certain ETFs’ rebalancings, the stocks concerned would make a price gain of 0.67 per cent on average in the five days prior to the index rebalance date. A “price reversal” of 0.2 per cent would then occur within 20 days of the same date.

This is fairly technical stuff, but it can certainly make a difference to your end returns. Li notes that the average 0.67 per cent paid in execution costs was three times higher than that paid in trades of a similar size by institutions. To quantify this further, avoiding the problem would help a $2m (£1.47m) retirement pot that accrues over 30 years save an extra $29,000 by the point of retirement. As Li notes on the 0.67 per cent figure: “This high cost is especially surprising because ETF rebalance trades are generally rule-based and not information-driven.”

While ETFs inevitably do need to rebalance to stay in sync with the index they track, the paper highlights some solutions. Some ETFs cut back on their costs by spreading out their rebalancing trades across 10 days, for example. Other funds use self-designed indices to avoid any pre-announcement of rebalancing decisions.

So this is an issue that can and should be addressed – as well as being another good example of how costs, like returns, can compound over time. As Li notes: “Even not-so-complex execution strategies, eg simply camouflaging either the timing or the underlying stock of a trade, can lead to considerable execution-cost savings for passive investors.” It’s a problem to be solved.

Having said that, I do struggle to see the problem itself as a gamechanger for passive investors, who have benefited richly from strong returns, a natural element of diversification and plummeting fees in recent decades. With most active managers still struggling to consistently beat mainstream stock markets, shareholders in ETFs have certainly not had a raw deal. And while both fees and costs are important, it can never be stressed enough that what you buy, and why, remain two of the most important elements of investing.