On the hidden costs of passive investing

ArXiv ID: 2506.21775 “View on arXiv”

Authors: Iro Tasitsiomi

Abstract

Passive investing has gained immense popularity due to its low fees and the perceived simplicity of focusing on zero tracking error, rather than security selection. However, our analysis shows that the passive (zero tracking error) approach of waiting until the market close on the day of index reconstitution to purchase a stock (that was announced days earlier as an upcoming addition) results in costs amounting to hundreds of basis points compared to strategies that involve gradually acquiring a small portion of the required shares in advance with minimal additional tracking errors. In addition, we show that under all scenarios analyzed, a trader who builds a small inventory post-announcement and provides liquidity at the reconstitution event can consistently earn several hundreds of basis points in profit and often much more, assuming minimal risk.

Keywords: passive investing, index reconstitution, tracking error, liquidity provision, cost analysis

Complexity vs Empirical Score

• Math Complexity: 7.5/10
• Empirical Rigor: 4.0/10
• Quadrant: Lab Rats
• Why: The paper is highly mathematical, employing continuous-time stochastic calculus with Brownian motion, permanent and temporary impact models, and game-theoretic equilibria (Nash, Stackelberg), but it lacks backtested strategies, explicit datasets, or statistical metrics, relying instead on stylized analytical models.

  flowchart TD
    A["Research Goal<br/>How can passive investing reduce costs & capture profits?<br/>Index Reconstitution Case"] --> B["Methodology & Data<br/>Simulate Zero-Tracking-Error vs. Gradual Acquisition<br/>Real-world Index Announcements"]
    B --> C["Computational Process<br/>Quantify Slippage Costs<br/>Analyze Liquidity Provision Opportunities"]
    C --> D["Key Findings / Outcomes<br/>1. Passive approach costs ~100s bps vs. Gradual<br/>2. Liquidity providers earn 100s bps profit with minimal risk"]