Demystifying Index Rebalancing: An Analysis of the Costs of Liquidity Provision

Abstract

Recent academic studies claim that price impacts associated with index rebalancing can be large and may represent a hidden cost to fund investors. The authors examine the return behavior around 18,871 rebalances for the Russell indexes from 2016–2021. A key difference from the literature is that they estimate net flows for each stock aggregated across all Russell indexes rather than the gross flows into each index. This is important because stocks migrating from one index to another may see positive or negative flows depending on the assets tracking those indexes. They find many instances in which the costs of liquidity provision, as measured by the beta-adjusted temporary impact, are negative. This is consistent with a highly competitive market for liquidity provision.