There’s an obvious incentive for the promoters of a new index to flatter its historical "performance" by taking an optimistic view of how much it would have cost to buy and sell the index constituents over time. And while cap-weighted benchmarks are largely self-rebalancing, typically generating only a few percentage points of turnover a year, newer index concepts can easily involve annual internal index turnover of hundreds, even thousands of percent.

Historically, it appears that many index providers have dealt with the thorny problem of internal trading costs very simply—by disregarding them completely.

“Turnover-related costs...[have] been widely ignored in index construction, based on the assumption that [these] are negligible for the typical investor. Index providers essentially follow the basic theory that (equity) markets are free of transaction costs,” Konrad Sippel of STOXX writes in an article to be published in the September/October Journal of Indexes Europe, in an issue focussing on index tradeability (you can sign up for a free subscription here).

“Another reason for not including cost-related elements is of course that these are very hard to measure transparently and consistently, as each investor has different cost structures, depending on their individual circumstances. The introduction of client-specific cost elements would dilute the function of an independent and transparent index,” Sippel goes on to point out.

In other words, trading costs incurred by index-related fund management activity may end up being reflected in tracking error of portfolios run against the index, rather than being internalised in the index’s return itself. But there is no common practice in this area. Some (fixed income) index providers do make a charge to their benchmarks’ return to reflect the cost of bonds’ entry and exit into the index portfolio. Equity indices tend to be calculated on the basis of recorded end-of-day trades in the index constituents, presenting a problem if index-tracking funds can’t deal on the same terms.

There are no easy answers here. Index tradeability is a subject that involves complex questions of market structure, technology and regulation. But it’s an increasingly relevant one as the number of smart beta launches multiplies.

As passive fund management moves further away from its cap-weighted roots, and as more and more markets suffer from patchy liquidity, checking what internal turnover a newly advertised index strategy generates and what the associated trading costs are is vital.

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