Management fees and commissions are hardly the only costs an investor needs to consider. We quantify the price impact created from buying and selling stocks when rebalancing index-tracking equity portfolios, and find the impact can significantly erode the expected excess returns of indexing strategies.

Because most index-tracking managers trade in unison when the index rebalances, the prices of stocks they buy are temporarily inflated, and those they sell are temporarily depressed. As prices revert in the days following the rebalance, investors lose money. Market impact is a very real trading cost, but is hidden from the investor because the portfolio’s value changes simultaneously with the index’s. A better understanding of how indices are designed can help investors select those with the greatest potential to deliver excess return net of realistic market impact costs.