Quant chart: Outsmarting the crowd during index changes

Index changes – such as which companies will be added and removed – happen on a specified rebalance date and are announced by index providers in advance. Due to their requirement to closely track public indices, passive strategies are therefore vulnerable to index front-running, where active managers exploit the announced index changes in a way their passive counterparts cannot.

This leaves passive strategies to buy stocks at relative price peaks and sell at relative lows. The index effect describes this abnormal return pattern – where the stocks to be added to an index outperform in the days before the addition and underperform in the days after. A reverse pattern also holds for index deletions. These patterns have not only been documented for major indices such as the S&P 500, but also for factor indices.¹

Passive strategies are tasked with minimizing the tracking error to their respective benchmarks and, as such, tend to incorporate index changes only on the effective date. Conversely, active investors are free to trade after the announcement, which typically happens weeks in advance, or even earlier based on predicted index changes (using index methodology), with the knowledge that passive investors are obliged to follow the index.

While the increase in passive investing would seem likely to amplify these patterns, others argue that these have in fact declined, with market participants either increasingly trading on anticipated changes or by creating arrangements where other institutions stand ready to provide liquidity to indexers. ²

Figure 1 revisits the index effect for the MSCI World Index additions from 2001 to 2024, showing the relative performance of the additions in the 20 days prior to and proceeding the index rebalance. It is clear that incoming stocks to the index outperform by about 2% before inclusion (t=0). However, after these stocks are added to the index, the outperformance is largely reversed, meaning that portfolios that trade directly upon the rebalance date buy these stocks at the worst moment.

This creates a hidden cost for passive investors, as the effect is embedded in the index, meaning they don’t underperform the benchmark but still bear the return impact. As a result, many investors remain unaware of how these dynamics affect their returns.

While we see that the patterns are more pronounced during the first half of our sample from 2001 to 2012, we still observe the index effect in the second half.³

Robeco’s quant strategies, such as Enhanced Indexing or more active strategies, have the flexibility to avoid these hidden costs by considering these effects when trading for our clients. While our proprietary stock selection models and risk management are the engine behind these strategies, a focus on practical portfolio management, optimal trading, and accounting for hidden costs such as the index effect is part of our ethos that every basis point counts. This agility enables Robeco investors to outsmart the crowd.

Footnotes

¹ Cf., Shleifer, A. (1986), Do demand curves for stocks slope down? The Journal of Finance, 41(3), 579-590, Huij, J., & Kyosev, G. (2016), Price Response to Factor Index Additions and Deletions, SSRN Working Paper No. 2846982 ,and Blitz, D., & Marchesini, T. (2019), The Capacity of Factor Strategies, Journal of Portfolio Management, 45(6), 30-38.
² Greenwood, R. M., & Sammon, M. (2024), The Disappearing Index Effect, The Journal of Finance, forthcoming.
³ In unreported results, we find similar but opposed patterns for index deletions, i.e., stocks announced to be removed from the index underperform before the actual rebalance and outperform after the rebalance.