NEW YORK ( TheStreet) -- Insider Monkey can understand why index funds are so popular. Index funds don't eliminate the unnecessary and harmful costs of investing but they significantly minimize them. Investing in index funds is not passive investing and there are some hidden costs that index fund investors must bear.
The most common
The S&P 500 index is composed of the 500 largest companies. However, the ranking of the 500 largest companies in America changes nearly every second as stock prices fluctuate up and down. This isn't a big deal for companies that are at the top of the rankings. However, at the bottom of the table, some companies drop out of the list while other companies manage to sneak into the top 500. As a result, the S&P periodically makes public announcements, drops some companies from the list and adds others. What do you think happens before and immediately after these announcements?
Since managers sheepishly follow the indices' portfolio weights in order to minimize their tracking error. They hold on to the dropped companies till the last second while nimble traders sell them days or weeks before they're dropped. They also don't start buying the newly added companies until they're officially added while nimble traders already have the new stocks in hand.Since most of these trades were artificially induced, they are lopsided and cause big market impacts. Dropped companies underperform, newly added companies outperform around the event date, and guess who foots the bill? Yep -- index fund investors.