Case Four Group 17 
1. Arbitrary constraints on portfolios (e.g. like the ones faced by index funds) can be very costly. Explain.
Influenced by the Nikkei 225 reconstitution, institutional investors who track the Nikkei 225 had no choice but to rebalance their portfolios to match the composition and weights of the new index. This Nikkei 225 reconstitution replaced the 30 smaller and lower-priced securities with 30 larger and higher-priced stocks, which subsequently would reduce the relative weights of the remaining 195 securities. Thus, under this circumstance, index funds would not only have to buy the additions and sell the deletions, but also unload some of their holdings in the remaining 195 securities to satisfy the arbitrary constraints of rebalancing. However, costs relative to rebalancing may be rather high.
Firstly, since at least US$25 billion of institutional assets were tied directly to the Nikkei 225, and much more were held by “quasi-indexers”, the trade volumes were expected to increase tremendously in response to this reconstitution, which definitely exerted a greater impact on the demand for the additions and the deletions in the stock market. Potentially soaring demand for the additions would overprice them, while the potentially huge selling of the deletions would underpriced them. It means index funds had to pay more than the actual fair market value to buy the additions and received less from the selling the deletions, which undoubtedly elevated the cost of rebalancing.
Secondly, arbitrary constraints imposed on index funds would increase transaction costs. In Japan, depart from exchange fees, most Nikkei 225 index stocks could be bought and sold at an average bid-ask spread of 25 basis points, which was higher than the Nikkei 225 Future and TOPIX future. If index funds allocated more capital to the stocks whose prices were expected to change the most, they needed to rebalance their portfolio more frequently, which exaggerated the transaction costs. Even if
Influenced by the Nikkei 225 reconstitution, institutional investors who track the Nikkei 225 had no choice but to rebalance their portfolios to match the composition and weights of the new index. This Nikkei 225 reconstitution replaced the 30 smaller and lower-priced securities with 30 larger and higher-priced stocks, which subsequently would reduce the relative weights of the remaining 195 securities. Thus, under this circumstance, index funds would not only have to buy the additions and sell the deletions, but also unload some of their holdings in the remaining 195 securities to satisfy the arbitrary constraints of rebalancing. However, costs relative to rebalancing may be rather high.
Firstly, since at least US$25 billion of institutional assets were tied directly to the Nikkei 225, and much more were held by “quasi-indexers”, the trade volumes were expected to increase tremendously in response to this reconstitution, which definitely exerted a greater impact on the demand for the additions and the deletions in the stock market. Potentially soaring demand for the additions would overprice them, while the potentially huge selling of the deletions would underpriced them. It means index funds had to pay more than the actual fair market value to buy the additions and received less from the selling the deletions, which undoubtedly elevated the cost of rebalancing.
Secondly, arbitrary constraints imposed on index funds would increase transaction costs. In Japan, depart from exchange fees, most Nikkei 225 index stocks could be bought and sold at an average bid-ask spread of 25 basis points, which was higher than the Nikkei 225 Future and TOPIX future. If index funds allocated more capital to the stocks whose prices were expected to change the most, they needed to rebalance their portfolio more frequently, which exaggerated the transaction costs. Even if