S&P 500 Indexers, Delegation Costs, and Liquidity Mechanisms

Abstract

The largest S&P 500 indexers replicate the index with tracking errors of just several basis points per year. Maintaining such small errors requires a nearly exact-replication strategy and precludes profiting from trading much before or after index changes. A strategy of trading at the open following the announcement of a change, rather than at the change, adds 19.2 basis points more return per year with virtually no added risk, but with substantial tracking errors. This additional return is a measure of the delegation costs in monitoring an indexer through tracking errors. The paper then shows that less than half of indexers always follow an exact-replications strategy, consistent with the hypothesis that they are trying to recoup some of these delegation costs. Further, market mechanisms have evolved that allow some exact-replication indexers to recapture a portion of these costs.