The Quiet Costs of Indexing That Impact Long Term Returns

Why Indexing May Not Be as Simple or Cheap as It Seems
Many investors treat index funds as a low-cost, passive way to access the broad market. While that worked well in the past, this approach now comes with hidden pitfalls.

Here are the key issues:

1. Not All Indexes Are the Same

• Different index providers (e.g. MSCI, S&P, FTSE) produce very different returns: over the past two decades, developed-market indices have varied by ~1% a year, and emerging market indices by as much as ~2.7%.
• These differences come down to design decisions –  market coverage, security eligibility, and rebalancing frequency.
• In short, an index is not the same thing as “the market.”

2. Trading Costs Hidden from View

• Index funds must mirror the index when it changes, meaning many funds buy and sell simultaneously.
• Before these rebalancing events, trading volume can spike massively (20x–50x).
• Because index changes are pre-announced, sophisticated traders (like hedge funds) can front-run the trades.
• As a result, index funds may “buy high and sell low,” costing them 3–4% on average around reconstitution.
• These costs often match or exceed the visible management fees (expense ratio), effectively doubling the true cost.
• Even more concerning, these costs don’t appear in standard performance metrics like tracking error if the same index is used as both investment and benchmark.

3. Risk of Style Drift

• Index strategies can suffer because they rebalance infrequently. As company characteristics evolve, the index may no longer reflect the true style it claims (e.g. small-cap, value).
• New contributions continue to flow into the same stale roster, worsening the mismatch.
• Even rebalancing may not fully correct this, depending on index construction.

A Smarter Way Forward

Rather than rigidly track a single index, investors can benefit from a more flexible, systematic approach:

• Determine how much tracking error you are comfortable with, then look for strategies that target higher expected returns within that tolerance.
• Use an implementation process that is systematic yet flexible – potentially staying within 25–75 basis points of tracking error relative to a broad market, while adapting to conditions.
• This allows for more thoughtful trading, better liquidity use, avoidance of costly reconstitution spikes, and more active risk management.

Final Thought

Low management fees are appealing, but they don’t tell the full story. With large sums being indexed today, even small inefficiencies can create meaningful cost leakage. By recognising and addressing these hidden costs, investors can potentially improve their net returns in a significant way.

Call to Action

If you would like to explore better ways to structure passive allocations, speak with the experts at Oreana Private Wealth. Our team can help you design and implement a more efficient, cost-effective investment strategy. Please get in touch.