When it comes to investing, there are many things we cannot control.  For example, we cannot control, let alone predict, investment returns.  On the other hand, there are things we can and should control, such as the costs of our investments.  The popularity of index-based mutual funds and exchange-traded funds (ETFs) has risen dramatically over the last decade in part due to their purported cost benefits.  And it’s true that when comparing the annual expenses of index funds with their actively-managed counterparts, those of index funds are generally lower.  To some extent this is due to the lack of any need for highly-paid researchers to identify and select securities for the fund to purchase.  Instead, the index fund simply purchases a list of securities in certain proportions based on a publicly-reported index.  You don’t need a PhD or even a CFA to be able to do that.  You might be surprised to learn, however, that there’s still a cost to track that index, and it might be quite a bit higher than you’d think.

The problem occurs when the funds need to rebalance their holdings to match that of the index.  Take the Russell 1000, for example.  It’s an index comprised of the 1000 largest stocks in the U.S., weighted by market capitalization (that is, the total amount of each company’s outstanding stock times its current price).  When a fund that tracks the Russell 1000 is created, its holdings exactly match the index.  But over time, the capitalizations of the various companies change as their performance causes them to fall in or out of favor with investors.  This changes their proportions in the index, and may even cause some to drop out if their market cap drops too much.  At the same time, smaller companies may grow and become eligible for inclusion in the index.

It can be costly to change an index frequently, so some are reconstituted only annually.  In the case of the Russell 1000, the reconstitution date is June 26.  Since so many funds track that index, on June 26th the demand to purchase or sell the stocks that have changed is substantial.  This causes the prices of those stocks to be driven up or down depending on the volume of shares that need to be traded.  The result is that the funds that track the index are forced to purchase or sell those stocks at inflated prices, which impacts their overall performance.

Gerard O’Reilly, Head of Research at Dimensional Fund Advisors, estimates that the cost of the reconstitution on U.S. large cap indices like the S&P 500 and the Russell 1000 has historically been between .10% and .20% annually.  That may not sound like much, but for an index fund that tracks one of the largest and most liquid market segments in the world, it’s significant.  The SPDR S&P 500 ETF, for example, has a reported annual expense ratio of .09%.  The total cost after adding in the cost of reconstitution could be as high as .29%.  That’s quite a difference!  And for U.S. small cap indices like the Russell 2000 – where the reconstitution can involve even larger percentages of the outstanding stock of the companies in the index – O’Reilly estimates the additional cost to have been as much as .50% to 1.00% or even higher.

This is not to suggest that investing in index funds is a bad thing.  Or that these reconstitution costs will remain constant in the future.  But there are costs associated with every investment, even those as simple as index funds, which may not be apparent.  Proper due diligence is necessary if you are to effectively understand and manage the costs of your investments.  It’s to everyone’s benefit to dig under the covers and find out.