The last business day of May was among the busiest for share traders around the world. It is one of the days that MSCI, a large index provider, rebalances many of its indices; restating the companies it believes to be representative of a particular market.

For investors who track one of MSCI’s indices, this is important because they have to buy or sell shares to reflect the changes. Some trades will be fairly small, as minor adjustments are made to individual weightings, but in some cases, entire holdings need to be dropped or acquired.

This activity creates a spike in the volume of shares traded as some of the world’s biggest fund managers are motivated to go into the market at the same time. The volume of shares traded on the German and UK markets on the last day of May was around 60% higher than on the day before and the day after1. This can have some interesting consequences for share prices.

Here is an illustrative example of what can happen when a share enters the index, requiring index trackers to buy.

Spike

Source: Dimensional. For illustrative purposes only.

The index provider announces the index changes some time before the effective date. This causes an initial spike in volume and price, followed by a longer run up in the share price. On the effective date there is a bigger spike in trade volume and price. In some markets, much of this activity occurs in the last few minutes of trading as fund managers enter the closing auction to ensure they get the same price as the index – whatever that price is. After the effective date, the price generally settles a little lower.

Funds that track an index are a sensible way for some people to gain exposure to a market, but there are trade-offs to be managed. This is one of the reasons we use investment managers that, among other things, have more flexibility and are able to trade stocks whenever the expected benefits outweigh the potential costs. It’s the trading equivalent of cutting your journey time to work by having the freedom to avoid rush-hour traffic.

The differences on each individual trade might be small but, as is so often the case with investing, over a lifetime these small differences add up.

1.Source: Dimensional/Bloomberg.

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