The Dirty Little Secret Of Passive Investing

The Dirty Little Secret Of Passive Investing by Michael Aked, Research Affiliates

Passive investments have a dirty little secret: Their gross returns are materially depressed by implicit implementation costs. You don’t see these costs in performance attributions, unbundled management fees, or even standard trading cost analyses. But as we recently pointed out in a Journal of Trading article (Aked and Moroz, 2015), the fact that they are unobserved doesn’t mean they don’t exist, can’t be measured, or shouldn’t be taken into account when selecting an index strategy. In particular, the implementation of popular capitalization-based indices is not costless; indeed, as a percentage of aggregate assets, their implicit trading cost is meaningfully higher than that of well-designed smart-beta offerings.

Hidden Trading Costs

Implicit trading costs are...