Index Fund Trading Costs are Inversely Related to Fund and Family Size

Abstract

Trading costs are a significant, but unobserved, drag on mutual fund performance. Because an index fund does not engage in securities selection or market timing, its net benchmark-adjusted return is equivalent, but opposite in sign, to its net trading costs. Using a sample of index funds, we find positive returns to scale at the fund and family levels. We also find greater fund size helps alleviate the higher trading costs associated with illiquid equities and that net trading costs are comparable in magnitude to expense ratios. Because reduced trading costs to scale are not limited to index funds, our results also have implications for active funds.