The Market Impact of Passive Trading

Abstract

Implementing a passive strategy with significant assets under management affects market values and thus gives rise to implicit costs in addition to the explicit costs, such as commissions and transaction-related fees. This article presents a conceptual framework and mathematical model for decomposing implicit trading costs and comparing them across active, passive, and smart beta strategies that do not involve frequent trading. The proposed framework, which improves on the weighted-average market capitalization/turnover approach, is intended to help providers and investors evaluate the investability or capacity of index-based strategies.