Whether a portfolio is run actively or passively the question of balancing between faithfully following the model or process and incurring trading costs is a perennial one. Although it might seem that traditional market capitalisation trackers might not have a problem with this in practice they are faced with many of the same issues as active managers when it comes to index rebalancing, new issues, rights issues and other corporate actions.
At the heart of the dilemma is the question of determining if the additional costs of trading will be recouped by a better return in the long run. Some hard-line adherents of traditional trackers will take the view that the returns are almost immaterial as the objective of the fund is to track its designated index as closely as possible. In the case of new issues that may mean that a tracker fund has to use derivatives to ensure getting adequate exposure in a thin market where stock may just not be available. Active fund managers may find a favourite stock has performed as he or she had hoped, or better, and it now represents a worryingly large percentage of the portfolio. That leaves it exposed to any bad news that might damage the share price or perhaps vulnerable to a forced sale in adverse conditions if he or she is hit with redemptions.
The only thing we know for sure is that trading costs money. Most directly these are the costs of commission and the spread, but also include the indirect cost of foregoing further gains from that share in capital growth or dividends. Reinvesting the proceeds also incurs the costs of commission, stamp duty for UK shares and once again the spread between the buying and selling price. Although this last element is less of a problem in larger, more liquid shares than in smaller tightly held shares it is still a cost.
The alternative is to ride with the discrepancies between what allocation the portfolio should have with what it actually has. This is where traditional market cap trackers gain; they just run the winners and gain from the well-documented momentum effect. Shares that have recently done well continue to do well. Less popular shares fall by the wayside and eventually become a part of the dust in a portfolio.
This is fine in a…
This statement is wrong...
Market cap trackers rebalance back to index weights every quarter so there is little danger of any one stock becoming dangerously large
Market cap trackers, by definition, are capitalisation weighted. As the price rises, the weight of the stock in the index naturally rises, there's no rebalancing. Unlike equal weighted indexes, the reason cap weighted indices are so cost effective is that trading (rebalancing) doesn't occur on price rises.
This also means (in contrast to your statement) that market cap weighted indexes can become grossly overexposed to extreme price rises in mega cap shares... as is seen when a single stock starts to dominate an index (e.g. Apple) or a whole set of stocks does (e.g. tech in dotcom bubble). One could argue that FANG stocks are overly dominating the Nasdaq right now.
The problem with cap weighted index trackers (for a factor investor like me) is that they don't rebalance. If you don't rebalance then it becomes impossible to capture the momentum or value effects. You have to harvest these market rewards through periodic rebalancing. They are by definition dynamic (or active) premiums... rather than passive.
