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The index premium and its hidden cost for index funds

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  • Petajisto, Antti
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    Abstract

    This paper empirically investigates the index premium and its implications from 1990 to 2005. For additions to the S&P 500 and Russell 2000, we find that the price impact from announcement to effective day has averaged + 8.8% and + 4.7%, respectively, and -15.1% and -4.6% for deletions. The premia have been growing over time, peaking in 2000, and declining since then. The implied price elasticity of demand increases with firm size and decreases with idiosyncratic risk, supporting theoretical predictions. We also introduce a new concept that we label the index turnover cost, which represents a hidden cost borne by index funds (and the indexes themselves) due to the index premium. We illustrate this cost and estimate its lower bound as 21-28 bp annually for the S&P 500 and 38-77 bp annually for the Russell 2000.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Empirical Finance.

    Volume (Year): 18 (2011)
    Issue (Month): 2 (March)
    Pages: 271-288

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    Handle: RePEc:eee:empfin:v:18:y:2011:i:2:p:271-288

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    Web page: http://www.elsevier.com/locate/jempfin

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    Keywords: Index premium Index turnover cost Index fund S&P 500 Russell 2000;

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    Cited by:
    1. Yen-cheng Chang & Harrison Hong & Inessa Liskovich, 2013. "Regression Discontinuity and the Price Effects of Stock Market Indexing," NBER Working Papers 19290, National Bureau of Economic Research, Inc.
    2. Martijn Cremers & Antti Petajisto & Eric Zitzewitz, 2012. "Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation," NBER Working Papers 18050, National Bureau of Economic Research, Inc.
    3. repec:eme:mfipps:v:36:y:2010:i:3:p:380-402 is not listed on IDEAS
    4. Eric Belasco & Michael Finke & David Nanigian, 2012. "The impact of passive investing on corporate valuations," Managerial Finance, Emerald Group Publishing, vol. 38(11), pages 1067-1084, November.

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