There are also opaque ETFs camouflaging what they trade by tracking their issuer’s own index – for instance, the Schwab 1000 ETF tracking the Schwab 100 index – which creates a considerable rebalance cost saving of 30 bps per trade versus passive ETFs. They do this by adjusting their baskets both in-between rebalance announcements and implementation dates, or by delaying rebalancing trades until after trading activity has normalised. Crucially, these ETFs outperform their “sunshine trading” peers by 7.3 bps a year. Those hiding when they trade only report their month-end holdings, meaning the pace at which they trade is unknown to investors. Li terms these “opaque ETFs” and they either hide when or what they trade. What is damning is that active and less transparent ETFs in the US illustrate this kind of performance drag is not inevitable. In fact, Li argued the cost of this kind of mechanical rebalancing is “comparable to total management fees charged by ETF managers”. “Given these poor execution strategies, these uninformed mechanical traders are paying higher execution costs than informed traders.” “This high cost is especially surprising because ETF rebalance trades are generally rule-based and not information-driven,” Li said. This results in an average performance impact of 14.6 bps per year. Most importantly, stock prices rise by an average of 67 basis points (bps) over the five days prior to index rebalancing and fall 20 bps in the 20 days following. Unfortunately for the 56% of US-listed ETFs passively tracking indices or employing “sunshine trading”, their methodologies mean they have sluggish rebalance processes, leaving them vulnerable to higher transaction costs and frontrunning by opportunists.īy tracking public indices that announce constituent changes five days prior to rebalancing, ETFs lose out on five days of what is normally upward price action, meaning the tendency to buy high is baked into their methodologies.īy trading at 4pm closing prices on rebalance days, Li said the ETF trades are large, abrupt, not driven by informational advantages and are fully predictable. In fact, Li found the median rate of portfolio turnover in US-listed ETFs tracking US equities was 16% in 2020, meaning the cost of portfolio reshuffles becomes a highly relevant factor when weighing up cost of ownership and performance drag. The research, titled Should Passive Investors Actively Manage Their Trades?and authored by PhD candidate Sida Li, stated regular rebalancing sees ETFs undergo a “significant amount of trading” in response to index constituent changes, IPOs, mergers and delistings. ![]() ![]() ![]() The adage that all returns equal the market before costs has been a calling card for passive ETFs charging low fees, however, a recent paper from the University of Illinois has found hidden trading costs borne by rules-based strategies slowly erode long-term returns.
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