S&P 500 Indexers, Tracking Error, and Liquidity

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Abstract
It is widely known that stocks added to the S&P 500 index experience abnormal returns on announcement. Why then do S&P 500 indexers not trade at the opening price immediately following announcement of a change in the index, which would gain them an average of 19.2 additional basis points of return per year? The catch is a much higher standard deviation of tracking error. To achieve the low tracking errors observed in practice, an indexer must closely follow an exact-replication strategy. That two of the largest indexers have enhanced their returns indicates more active management than just holding all 500 stocks in the exact same proportions as the index. Practitioners interviewed suggest?and the empirical evidence confirms?that many indexers are effectively compensated for entering into bilateral agreements with providers of liquidity to trade at the closing price. The patterns of abnormal returns for changes in the index are exactly those that are needed to compensate liquidity providers for the risks t...