Index design and implications for index tracking

Institutional Investor
Publication Type:
Journal Article
Journal of Portfolio Management, 2004, 30 (2), pp. 89 - 95
Issue Date:
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Index funds aim to deliver the returns and the risk of an underlying benchmark index. Researchers focus on four exogenous determinants, revisions in S&P 500 index composition, share issuances, share repurchases, and spin-offs, as well as two related factors that are associated with index maintenance rules, the treatment of dividends by the index, and implicit transaction costs that are incurred when changes arise in the Index Divisor. This research on the exogenous determinants of tracking error in S&P 500 index funds that arise from amendments to the Index Divisor and the effect of transaction costs and the treatment of dividends should be of significant interest to the investment industry, particularly index committees, investors, and mutual fund managers. If they better understand the drivers of tracking error, market participants can more easily see the implications that maintenance of an index might have for index-mimicking portfolios. Tracking error is found to be significantly related to index revisions, share issuances, spin-offs, share repurchases, index replication strategy, and fund size. And index funds also exhibit a seasonal pattern in tracking error.
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