The viability of alternative indexation when including all costs

Abstract

We ascertain the performance and viability of alternative indexation after including all relevant costs. Onerous costs, associated with forgoing the automatic rebalancing of traditional price-weighted indexes, may occur as a consequence of the frequent trading required to replicate alternatives accurately. The largest cost associated with replication is the cost of adversely moving the stock price as a result of trading the stock, known as price impact cost. It is unknown to what extent alternative index funds suffer degraded performance as a consequence of such costs. We compare the performance of a number of well-known alternative indexes before and after costs with the traditional market-capitalization benchmark index under various alternative rebalancing frequencies, considering differing assets under management, and using various competing price impact cost models in order to measure the extent of the performance erosion that occurs due to costs associated with rebalancing. We find that if we exclude all costs, the alternative indexes generate higher returns compared to the traditional benchmark, mainly as a consequence of higher risk exposures. However, as fund size and consequently the costs of rebalancing increase, the outperformance is reduced to a statistically insignificant level. In effect, we find that as assets under management and consequently rebalancing costs increase, those greater costs almost completely erode the higher returns due to the innate risk exposures of alternative indexes. This finding is robust to the choice of price impact model. We also consider alternative index viability in terms of execution and holdings and find that many alternative indexes are not viable from this perspective either. The salient lesson is that we should not ignore the implementation of alternative indexes when considering their performance. We conclude that the traditional market-capitalization-weighted index will remain popular due to its reliance on elegant theory, simplicity, ease of implementation, vast investment capacity, and inherent low costs.