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1) SIMPLYSTATED January 2016 The Dirty Little Secret of Passive Investing by Michael Aked, CFA Passive investments have a dirty little secret: Their transactions in the market. After all, an index is just gross returns are materially depressed by implicit a model portfolio, and it cannot be implemented above implementation costs. You don’t see these costs in and apart from the laws of managing money. To attract performance attributions, unbundled management sellers for stocks you wish to buy, you have to pay fees, or even standard trading cost analyses. But as more. To attract buyers of stocks you wish to sell, you we recently pointed out in a Journal of Trading article (Aked and Moroz, 2015), the fact that they are unobserved doesn’t mean they don’t exist, can’t be measured, or shouldn’t be taken into account when selecting an index strategy. In particular, the implementation of popular capitalization-based indices is not costless; indeed, as a percentage of aggregate assets, their implicit trading cost is meaningfully higher than that of well-designed smartbeta offerings. need to ask for less. Market players are aware of the practice of paying indexers to accept the market close price. Blume and Edelen (2004) explain it this way: “Counterparties such as hedge funds or dealers can enter into bilateral agreements with indexers to trade at a yet unknown closing price on the change date and agree to share part of their expected trading profits with the indexers through a better net price than the closing price.” (Page 41) Hidden Trading Costs Implicit trading costs are the loss of performance due Blume and Edelen’s research confirms that indices to transactions occurring at prices that would not have bear implementation costs that are just right to prevailed if investors didn’t need to enter trades. compensate liquidity providers for the risks they would assume by providing tradable securities at the closing Decades of research have demonstrated that the cost of changes in the S&P 500 Index is significant and increasing.1 Consistent with earlier academic findings, Chen, Noronha, and Singal (2004) determined that, from announcement day to the effective date, the additional cost of a new index holding rose from 3% in the 1976–1989 period to about 9% in the 1989–2000 period. In our own research, for the 2011–2013 period, the one-year returns earned by additions to the S&P 500 were on average 13% higher than the returns of price on index rebalance days. Indices Are Not Passive Because indices are, to varying degrees, incomplete market portfolios, index construction amounts to active management.2 Providers choose index holdings by size, liquidity, sector, geography, profitability, and the like. Index designs run the full gamut, from highly systematic, rules-based procedures to largely discretionary, committee-based processes. In every case, the explicit selection criteria, weighting rules, existing index constituents. Investors pay a substantial and committee decisions directly affect indices’ active premium just because a stock becomes a member of shares. Index construction methodologies may seem the index. arcane, but their effects are far from inconsequential. This outcome is not unique to the S&P 500. It applies Capitalization-based indices are inherently biased to the management of any pool of money that requires toward including more liquid, higher-priced growth © Research Affiliates, LLC

2) January 2016 SIMPLYSTATED stocks and stripping low-priced value stocks of their Appendix: Trading Cost Calculations index certification. Conversely, indices that are not Implicit trading costs cannot be observed directly price-linked trade into depressed stocks and out of but they can be estimated. As to measure is to high-flying ones. Over the same 2011–2013 period manage, let’s outline the drivers behind our implicit covered by our internal S&P 500 analysis, we find that securities that our fundamentally weighted RAFI™ indices wish to buy have fallen by approximately 13% more than their peers. Liquidity providers have no incentive to pump the price of index holdings that are not weighted by market cap, because doing so would reduce—not increase—their potential profits. trading cost model : Implicit trading cost = k With some simplifying assumptions, five factors are responsible for the implicit costs associated with trading a strategy: • value of shares traded daily across all stocks in indices is their low market impact. Market capitalization the universe, scaled by a constant. closely tracks liquidity. Moreover, cap-weighted indices • turnover. This factor reflects the obvious fact changes. Thus, by design, they minimize this particular that if there were no trades, there would be no type of cost. be viewed as costless, especially in aggregate. Our Effective turnover, the second factor, is impacted by both replacement turnover and reweighting only trades they require are occasioned by index Nonetheless, capitalization-based indices should not The first factor is base impact, which is the ratio of the assets under management to the dollar One of the attractive features of capitalization-based are self-adjusting; they do not require rebalancing. The Base impact × Effective turnover × Tilt Coverage × Rebalance frequency implementation cost. • The third factor is tilt, the weighted-average ratio of the actual weight of a fund to the volume model indicates it would take over $1.1 trillion in assets weight of the index, with a volume-weighted for a RAFI index to match the current implicit index having the lowest implementation cost. implementation costs of capitalization-based indices.3 • constituents to the total trading volume of the Non-capitalization indices have higher implementation entire universe is the fourth factor, which we call costs on a dollar-for-dollar basis than capitalization- coverage. A portfolio that contains every stock based indices. This we do not contest. But it’s lunacy in the universe has coverage of 1. to believe that the implementation of popular capitalization-based indices is costless, that their The ratio of the total trading volume of the index • The fifth factor is rebalance frequency. More negative selection and weighting bias is zero, or that frequent rebalancing, all other things being equal, their implicit trading cost as a percentage of aggregate is associated with lower implicit intraperiod market assets is currently below that of well-designed smart- impact costs. The rebalance frequency applies at beta offerings. the individual stock level, not at the index level. Endnotes 1. 2. See Arnott and Vincent (1986); Lynch and Mendenhall (1996); and Kappou, Brooks, and Ward (2010). Even broad cap-weighted indices can be considered a form of active management, not so much against the capital markets they purport to represent, but against the macroeconomy. Arnott, Beck, and Kalesnik (2015) write, “From a macro-economy perspective, the cap-weighted market is making obvious and sometimes large active bets, presuming (using a 2014 example) that Apple will be the © Research Affiliates, LLC 3. largest source of risk-adjusted profits in the world, delivered to its shareholders in the decades ahead. Perhaps true. But it is not yet true. So, from a macroeconomic perspective, the market is making an active bet on Apple today, relative to the much smaller current macroeconomic footprint that it occupies in the U.S. and global economy.” Page 63. In this example, we do not give credit for the far-superior incentive alignment for liquidity providers for RAFI indices, nor for the selection and weighting criteria of the RAFI indices.

3) January 2016 SIMPLYSTATED References Aked, Michael A., and Max Moroz. 2015. “The Market Impact of Passive Trading.” Journal of Trading, vol. 10, no. 3 (Summer):5–12. Arnott, Robert, Noah Beck, and Vitali Kalesnik. 2015. “Rip Van Winkle Indexing.” Journal of Portfolio Management, vol. 41, no. 4 (Summer):50–67. Arnott, Robert D., and Stephen J. Vincent. 1986. “S&P Additions and Deletions: A Market Anomaly.” Journal of Portfolio Management, vol. 13, no. 1 (Fall):29–33. Blume, Marshall E., and Roger M. Edelen. 2004. “S&P 500 Indexers, Tracking Error, and Liquidity.” Journal of Portfolio Management, vol. 30, no. 3 (Spring):37–46. Chen, Honghui, Gregory Noronha, and Vijay Singal. 2004. “The Price Response to S&P 500 Index Additions and Deletions: Evidence of Asymmetry and a New Explanation.” Journal of Finance, vol. 59, no. 4 (August):1901–1930. Kappou, Konstantina, Chris Brooks, and Charles Ward. 2010. “The S&P500 Index Effect Reconsidered: Evidence from Overnight and Intraday Stock Price Performance and Volume.” Journal of Banking & Finance, vol. 34, no. 1 (January):116-126. Lynch, Anthony W., and Richard R. Mendenhall. 1996. “New Evidence on Stock Price Effects Associated with Charges in the S&P 500 Index.” NYU Working Paper. Available at http:/ / papers.ssrn.com/sol3/papers.cfm?abstract_id=1298790. ABOUT THE AUTHOR Mike Aked is a senior member of the Research and Investment Management group. He concentrates his efforts on research and implementation of global tactical asset allocation strategies. Previously, he served as a managing director at the University of Virginia Investment Management Company, where he worked on portfolio and risk management. He also has worked for Sunsuper, an Australian superannuation fund, and at UBS Global Asset Management across four continents. Michael received a BA (with honors) in applied mathematics from the University of Sydney, an MS in statistics from the University of Virginia, and an MS in financial mathematics from the University of Chicago. He is a member of CFA Institute and of the CFA Society of Washington DC. The material contained in this document is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it investment advice on any subject matter. Research Affiliates, LLC and its related entities do not warrant the accuracy of the information provided herein, either expressed or implied, for any particular purpose. By accepting this document you agree to keep its contents confidential. No disclosure may be made to third parties regarding any information contained in this document without the prior permission of Research Affiliates, LLC. The trademarks Fundamental Index™, RAFI™, Research Affiliates Equity™, RAE™, and the Research Affiliates™ trademark and corporate name and all related logos are the exclusive intellectual property of Research Affiliates, LLC and in some cases are registered trademarks in the U.S. and other countries. Various features of the Fundamental Index™ methodology, including an accounting data-based non-capitalization data processing system and method for creating and weighting an index of securities, are protected by various patents, and patent-pending intellectual property of Research Affiliates, LLC. (See all applicable US Patents, Patent Publications, Patent Pending intellectual property and protected trademarks located at http:/ /www.researchaffiliates.com/Pages/legal.aspx#d, which are fully incorporated herein.) Any use of these trademarks, logos, patented or patent pending methodologies without the prior written permission of Research Affiliates, LLC, is expressly prohibited. Research Affiliates, LLC, reserves the right to take any and all necessary action to preserve all of its rights, title, and interest in and to these marks, patents or pending patents. © Research Affiliates, LLC 620 Newport Center Drive, Suite 900 Newport Beach, California 92660 www.researchaffiliates.com