Passive investing, active decisions: The DAX index inclusion effect
The rising popularity of index‐replicating Exchange Traded Funds (ETFs) reflects the broader shift toward passive investing. However, the DAX 40 index incorporates an active component through inclusions and deletions, which affect investor returns. While the short‐term “index inclusion effect” around announcement and inclusion dates is well‐documented, we focus on long‐term post‐rebalancing dynamics. We show that newly included stocks between 2010 and 2023 outperformed the DAX 40 by an average of 33.2% during the 12 months before inclusion but underperformed an average of 36.1% over the subsequent 24 months. This mean reversion can be leveraged via a market‐neutral strategy that shorts newly included stocks on the inclusion date and pairs this with a long DAX ETF position. Maintaining the short for 18 months generates a statistically significant alpha relative to a Fama–French six‐factor asset pricing model, even after accounting for transaction costs. Our study reveals a hidden performance drag in the DAX 40 index, with important implications for passive investors in the index.