Buy High, Sell Low with Index Funds!

Traditional index funds match market performance and have negligible trading costs with low tracking error—or do they? Not actually—they routinely buy after high price appreciation and sell after high price depreciation. They also have significant trading costs from adding and deleting stocks. We show how index providers can construct better-performing indices that are less prone to performance chasing and have lower turnover. The changes we suggest have the potential to boost index fund performance by about 15 basis points a year with just 25 basis points of tracking error. That's a material benefit when fund managers compete based on fee differences as small as a single basis point!