Money Left on the Table III – A Deeper Look into the Effects of Liquidity and Reconstitution
Conventionally, the stock price is believed to have incorporated liquidity premium. When illiquidity is properly rewarded, some investors may forfeit short-term liquidity and harvest the liquidity premium. However, when it comes to passive investments, the performance is heavily reliant on the replicability and tradability of the components of the underlying index. With thinly traded securities, or at times of financial stress with dried-up liquidity, reconstitution may be challenging and lead to a significant tracking error.
We observed that the overlap with the float market-capitalization-weighted index fell steeply as the weights moved closer to liquidity weights. Although the overlap reduced as we moved closer to liquidity weights, the impact of reconstitution also reduced significantly. However, the reduction in impact was accompanied by an increase in turnover.
Therefore, a breakeven point could be established where the total cost, which includes the cost of turnover as well as the impact of reconstitution, is minimized.
- We observed that the overlap between float market-capitalization-weighted index (X à ∞) and indices with capping limit fell steeply when X moved from 2 to 1 for all size segments (see Exhibit 1 in Paper)
- Although the overlap reduces as we move closer to liquidity weights, the impact of reconstitution also reduces dramatically (see Exhibit 2 in Paper)
- Whilst there was a reduction in the impact of reconstitution as we moved closer to liquidity weights, it was also accompanied by an increase in the turnover of the indices (see Exhibit 3 in Paper)
To find out more about the trade-off between the impact of reconstitution and costs from turnover, please click here or on the graphic below to download our white paper.
Download the first and second Paper of our Money Left on the Table Series here: Money Left on the Table I – Passive Investing and the Effects of Reconstitution & Money Left on the Table II – Why You Should Think About the Timing of the Reconstitution