EExchange-traded funds are known for their transparency, allowing investors to instantly know what exactly they are investing their money in. However, this full disclosure of the underlying holdings also comes at a cost, as pioneers were able to capitalize on quarterly rebalances at the expense of these transparent ETFs.
According to academic research, U.S. index funds lose $ 3.9 billion annually by following predictable, rule-based indexing methodologies that are exploited by opportunistic market participants, the Financial Time reports.
âThe cost of negotiating mechanical rebalancing is high in many ways. This is comparable to the total management fees charged by ETF managers, âSida Li, a PhD student at the University of Illinois and author of the article, told the Financial Times.
The research was based on the regular, usually quarterly, rebalancing that passive ETFs perform to ensure that strategies stay aligned with the changing composition of their underlying index components.
Since passive ETFs adhere to a strict rule-based indexing methodology, market traders know what changes are going to occur before the rebalance date. Therefore, there is a window of opportunity to anticipate or capitalize on trades that they know rule-based ETFs need to make.
The potential for front running is made particularly easy because Li pointed out that the majority of US-listed equity ETFs not only announce their rebalances in advance, but also execute trades at the 4:00 p.m. close on rebalance days. the stipulated index.
As a result, research has found that the prices of stocks bought by ETFs rise on average by 67 basis points during the five trading days before their rebalance date, and then fall by 20 basis points over the next 20 days.
Based on the median portfolio turnover rate of 16% for U.S. equity ETFs in 2020, this front running translates into an average annual performance loss of 14.6 basis points.
This happens because ETFs report their net asset value on a daily basis, providing investors with daily disclosure of their underlying holdings. This is also done to help make the process of creating and redeeming ETF shares with baskets of underlying securities.
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