Index - transaction cost

[FrankCFA]

* Adapt from 2013 CFA AM Q4

For constructing index, which selection of index constituents method will result in higher transaction cost for the index tracker?

A) objective, clearly stated rules

B) subjective, flexible rules

[OMGMileyCyrus]

[Updated comment below]

[OMGMileyCyrus]

@OMGMileyCyrus

Reading 20 Market Indexes and Benchmarks of the CFAI text (page 108) provides a section on ‘Objective and transparent rules vs. judgment’:

" Transparency and objectivity are desirable characteristics of indexes because they allow investors to readily predict the changes in index constituents that might occur… Less transparency and the greater use of judgment by the index provider make it harder for investors to determine the constituents of an index and anticipate changes in it, making the index less investable and creating additional costs for tracking portfolios."

Essentially, index providers should have clear, transparent, and objective rules in place to ensure that investors don’t incur significant transaction costs when attempting to track an index.

If index reconsitution is not transparent or objective and is subject to judgment, such as when an index is reconstituted and securities are added to (removed from) an index, investors will be exposed to greater transaction costs, such as having to purchase (sell) a security that has experienced a price increase (decrease) after having been added (removed) to (from) an index.

Hope this helps!

OMGMileyCyrus

[FrankCFA]

Thanks!