The Market Impact Of Passive Trading by Michael Aked, Max Moroz, Research Affiliates Executive Summary The market impact, or implementation cost, of passive trading is composed of both explicit and implicit costs. The explicit cost is often referred to as implementation tracking error, defined as the observed difference between a fund’s performance and the index against which it is benchmarked. The implicit cost is the unobserved reduction in performance of the benchmark index as a result of trading activity. The relative contribution of each component is primarily determined by the implementation strategy. This article focuses on the implicit cost, which is harder to measure, and which is often the main component of an index fund’s implementation cost. The authors use a linear price impact model to derive implicit costs. Empirical evidence supports a linear model as a reasonable approximation for price in index rebalancing trades when trade size is less than average daily volume. In practice, it is likely that individual implementers are unaware of rebalancing trade size in the aggregate and unknowingly cluster trading at the market close. The authors consider the change in a security’s price as a function of trading execution to be an implementation cost, because the price change will disappear over the security’s holding period. The aggregate implicit implementation cost of a rebalancing is the summation of such costs across all stocks traded in the rebalancing. With some simplifying assumptions, five factors are responsible for the implicit costs associated with rebalancing: The first factor is base impact, which is the ratio of the assets under management to the dollar value of shares traded daily across all stocks in the universe, scaled by a... More