How to Utilize Anticipated ETF Rebalances

Passive investing enjoys substantial popularity and subsequently attracts the attention of researchers. We blogged about the boom of passive investing and market inelasticity in the past. However, the novel research by Li (2021) examines a different perspective. With the boom of passive investing, we are also witnessing a boom of index-tracking mutual funds, but especially index-tracking ETFs. 

For many investors, passive investing can be a no-brainer and is suggested by many, especially those who think that the walk is random. However, it does not mean that the passive investors do not trade – the ETFs trade instead of them. The indexes that are being tracked are rebalanced to account for changes in the market cap, mergers, delistings, or IPOs. The novel research shows that it matters how the ETFs trade. The author recognizes three possible rebalancing strategies: sunshine trading, camouflaging when to trade, and camouflaging what to trade. In the first case, the ETFs track publicly available indexes that announce changes five days before rebalances. These ETFs react to the changes by adding or dropping stocks only on the close of index rebalancing days. Although transparent, it is costly because the stock prices tend to rise by 67 bps on average prior to rebalancing day. The second option is to camouflage when to trade, which perhaps allows more optimal trading that outperforms sunshine ETFs by 7.3 bps per year. The last option is to hide what to trade, in which case the ETFs are self-indexed and do not track public indexes. Consequently, ETFs are less transparent but more efficient. According to the research, costs to rebalance are 30 bps lower per trade for self-indexed ETFs compared to those tracking public indexes. 

So what about the key takeaways? The passive investors “trade,” and it does matter how. Even though the differences are not that big, for a long-term horizon, the differences compound. For active traders, the paper shows that the rebalancing of the ETFs could be utilized by trading in advance. 

Author: Sida Li

Title: Should Passive Investors Actively Manage Their Trades?

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3967799

Abstract:

Using novel daily holding data for exchange-traded funds (ETFs), I identify three types of ETFs that adopt distinct approaches to rebalancing their portfolios, which generates meaningful return heterogeneity. First, 56% of ETFs track public indices that pre-announce their rebalances, and they trade entirely on reconstitution days at closing prices. Their large, uninformed trades pay 67 bps in execution costs, a figure that is three times higher than what is paid in similar-sized institutional trades. Second, 7% of ETFs spread out their trades across 10 days and save 34 bps per trade or 7.3 bps per year. Third, 37% of ETFs use self-designed indices to avoid pre-announcements of rebalancing stocks and save 30 bps per trade. The alternative rebalance schedule leads to a tracking error of 10.6 bps per year and an information ratio of 0.69. For a $2 million retirement account that accrues over 30 years, the transaction cost savings rise to $29 thousand at retirement.

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