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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.

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