The Cost (to an Index Fund) of Turnover in an Index

A reader writes in, asking:

“When stocks enter or leave an index, an index fund is forced to sell the leaving stocks and buy the entering ones. I have heard that this results in a cost to the index fund. Is this cost big enough to matter much?”

There are two types of costs imposed on an index fund when stocks move in or out of the index that the fund tracks: transaction costs and front-running costs.

Transaction costs are the brokerage costs and bid/ask spreads incurred by buying and selling shares of a stock.

Indexes themselves, unlike index funds, have no transaction costs. As such, transaction costs would show up in the form of “tracking error” (i.e., the amount by which an index fund trails the performance of its respective index). As it turns out though, most index funds from reputable providers (e.g., Vanguard, Fidelity) don’t often trail their indexes by amounts significantly more than their expense ratios. In other words, the total transaction costs for such funds are often sufficiently small that they typically don’t even make an observable impact on fund performance.

Given the above, and given that transaction costs from stocks entering/leaving the index are only a part of an index fund’s overall transaction costs, we can confidently conclude that the transaction costs specifically resulting from changes in the index must be very small.

The second type of costs, front-running costs, are the reduction in performance that results from other parties bidding up the price of a stock by buying shares after the announcement that the stock will be added to a given index but before index funds buy it. It’s difficult to estimate such costs because they don’t show up as tracking error, because such costs affect the performance of the index itself as well as the performance of index funds.

In the last decade, two studies estimated the cost of front-running to be in the 0.2-0.3% per year range for index funds that track the S&P 500. That would certainly be a significant cost over time. However, other parties have argued that the cost has likely declined (and will continue to decline) as front-running opportunities are largely eliminated due to the idea becoming so well known.

In addition, you’re largely unaffected by such costs if you stick to “total market” funds, because your fund would already hold such stocks well before the bidding up that happens when the stock is announced for inclusion in something like the S&P 500.

So in short, yes, costs are imposed on an index fund when stocks are added to or removed from the index that it tracks. However, such costs (both transaction costs and front-running costs) tend to be very small, especially for the most diversified index funds.