According to Konrad Sippel, head of index development at STOXX, investors need to pay careful attention to the potential costs of investing in indices embedding an investment strategy. The potential performance benefits of such indices are heavily dependent on the assumptions made for trading costs, says Sippel, writing in the latest issue of the Journal of Indexes Europe.

“Strategy index concepts do not typically reflect the costs of portfolio turnover, and published index values suggest a higher strategy benefit than investors can actually achieve,” argues Sippel.

“The true performance impact of strategy indices is strongly dependent on the actual trading costs experienced by the investor. Investors therefore need to evaluate carefully the actual value added by a turnover-intensive strategy, depending on their specific cost structures.”

In his article, Sippel examines the effect of trading costs on one particular type of strategy index. So-called risk control strategy indices switch between a risky underlying asset (equities) and a non-risky one (cash), depending on the prevailing level of equity market volatility.

If the indicative cost of trading in the risky asset is below 90 basis points, Sippel shows, the strategy index can produce superior returns, but if trading costs are higher, the benefit disappears.

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