Flying high on index demand.

Photographer: Tim Boyle/Bloomberg

Can You Really Game Index Funds?

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Here is a Bloomberg News article about how banks and hedge funds are front-running index funds by buying stocks before they are added to indexes, and maybe the first thing to say is, man, remember when "front-running" meant something? Here is Wikipedia: "Front running is the illegal practice of a stockbroker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers." But then came "Flash Boys," which used the term to describe high-frequency traders "seeing an investor trying to do something in one place and racing ahead of him to the next," eliminating the broker/customer relationship (and the illegality) from the definition. Other HFT-related expansions of the term followed: If news comes out, and a high-frequency trader acts on the news in milliseconds while a retail investor takes minutes, then isn't the HFT front-running the retail guy? (No.) And now, basically any time anyone trades on public information before someone else, it's "front-running," albeit legal front-running:

Take American Airlines Group Inc., which joined the S&P 500 after markets closed on March 20. Because the addition of the carrier was announced four days earlier, nimble traders had plenty of time to get in front of the less fleet-footed. 

Four days! You didn't need to be a sophisticated low-latency computer algorithm to trade ahead of American's addition to the S&P 500 index. A regular human retail trader could have read the S&P news release on Monday afternoon, had dinner with friends, seen a movie, gotten a good night's sleep, spent Tuesday morning doing research to confirm that American was in fact going to join the S&P 500 and that a lot of index fund money tracks the S&P 500, gone out for a two-martini lunch, had 40 martinis, gotten blackout drunk, woken up in the hospital, spent 48 hours recovering and still had time to buy the stock before it joined the S&P on Friday afternoon. If it takes you more than four days to push a button, don't go around complaining that other people are too nimble and fleet-footed.

Though the index funds aren't complaining. The idea here is that when a stock is added to an index, the funds that track that index wait until right before it joins the index to buy it, giving smarter, less mechanical investors the chance to beat them to it and costing the index funds about 20 to 28 basis points a year (depending on the study). But the index funds deny that :

Managers at Vanguard Group, which oversees $3 trillion, “mitigate a good portion” of the risk by gradually building positions over time in stocks that are scheduled to be added, said Doug Yones, the Valley Forge, Pennsylvania-based firm’s head of domestic equity indexing and ETF product management.

“It just comes down to being smart with your trades,” he said. “It’s a big enough deal that index managers are aware and spend time and energy making sure there isn’t an impact.”

That said, there clearly is a lot of index buying on the index-add day, because otherwise you wouldn't get spikes like this:

Source: Christophe Bernard, Winton Capital Management

That's from this Winton Capital Management paper cited by Bloomberg News, and shows that the shares of companies being added to the S&P 500 index go up  by almost 7 percent on average in the 10 days leading up to the index-add date, and then lose back about 1.6 percent in the following 10 days. And clearly if there are people buying on day -9 and selling to the index funds on day 0, those people are making money.

What should you make of this? A couple of things. First: The value of market-making is hard to see and easy to criticize. Here's another paper cited in the article:

The price impact of index changes on the effective day of the change is generated by the coordinated demand due to index funds. The arbitrage activity consists of anticipating these changes days or even months earlier, buying the additions and then selling the entire position to index funds on the effective day. In effect, the arbitrageurs are thus helping to meet the large spike in demand by indexers by spreading the trade over a longer period of time.

Imagine all index funds bought their required shares in the five minutes before a stock was added to the index, and imagine no one "front-ran" them. (Imagine no one knew about the index add, or they forgot, or weren't allowed to trade for days beforehand.) Six minutes before the stock joined the index, it would be owned by the regular mix of holders: retail investors, long-term mutual funds, fast-money hedge funds, whatever. Then the index funds would have to go find billions of dollars worth of stock in five minutes, and persuade the owners to sell. Those owners -- again, many of them long-term owners who weren't looking to sell that day, or who weren't even at their desks in the relevant five minutes -- would have a lot of leverage to demand a high price. American Airlines traded one-fifth of its outstanding shares -- almost 10 days' volume  -- in one day when it was added to the S&P 500. Its stock was up 1 percent on the day (and 11 percent since the announcement earlier in the week). If you need to buy a fifth of a company's stock in five minutes, you're going to have to pay more than a 1 percent -- or even 11 percent -- premium.

The people who bought the stock on Tuesday and sold it to the index funds on Friday performed a market-making function: They knew that there would be a lot of concentrated demand for stock on one day, they knew there wouldn't be enough "natural" supply to meet that demand, and so they spread that demand backwards in time by buying ahead of the big demand event. They -- it's become a dirty phrase by now, but here it is -- supplied liquidity. And they got paid for doing it.  But trading ahead of anticipated demand looks a lot like front-running, for some definition of front-running,  so they look a little like villains. Even if they actually helped their supposed victims.

Second: One of my little stock-market obsessions is that index funds free-ride on the work done by active investors. Someone needs to make decisions that allocate capital to businesses. A world in which everyone indexes, and in which no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital to the right businesses.  That's not the world we live in: A lot of people still actively work to allocate capital, though they are in some regulatory disfavor and sometimes have a tough time making money. Part of the way they make money, or try to, is by trading against the index funds which free-ride off their labor, but which trade in a relatively mechanical, non-fundamentals-driven way. The index funds have the advantage of free-riding, but the disadvantage of being predictable. Stocks should go up when they join an index. That's the price that the index funds pay to active traders for picking stocks. Stock picking is valuable; active investors pay for it in fees, while passive investors pay for it in, you know, front-running or whatever.

Finally: This is perhaps another illustration of the fact that one of finance's greatest sources of profit opportunity is benchmarking. Here's a guy:

“Portfolio managers are aware of it, but some of them will say ‘My clients demand an index fund, and I’m going to give it to them come hell or high water,’” Michael Rawson, an analyst at Morningstar Inc., said from Chicago. “Yes, you matched the index return, but the investor is now worse off. You don’t hear about that as much.”

But what did the investor want? If he wanted the index return, he got the index return: By buying right at the time of the index add, the fund matched the index, even if the stock immediately went down. If he wanted just, like, as much money as possible, then I guess he'd be sad. But there are lots of ways to be sad. American Airlines is down almost 29 percent since it was added to the S&P 500. If you want as much money as possible, an index fund will constantly make bad decisions for you, decisions that are considerably worse than the one about buying stocks on the day they're added to the index. Of course, an active fund will also make bad decisions for you. Any investment strategy will constantly make bad decisions for you, measured against a perfect investment strategy that always makes as much money as possible.  All you can do is make some appropriate amount of bad decisions. The socially accepted norm for bad decisions is the index. If your index fund matches the index, you don't have to regret any of its bad decisions, whether that's the decision to buy American Airlines the afternoon it was added to the index, or the decision to buy American Airlines at all. If you strike out on your own, all your bad decisions are yours to regret.

Of course, in an economic sense losing a dollar getting front-run on index adds is just as bad as losing a dollar by failing to track the index. Money is money. But tracking the index eliminates regret. This is why corporate treasurers like to convert currencies at the daily benchmark fix, rather than timing their FX trading on their own. The fix might be better than they'd get trading on their own, or it might be worse, but either way it won't bring regret. Trading on their own brings a 50/50 chance of regret. And so banks ... ruthlessly exploited that benchmark. (And Libor. And ISDAfix. And maybe the gold fix. And so forth.) Most users of financial benchmarks just want to match the benchmark and avoid regret. They care considerably less about whether the benchmark itself is high or low. If you're out to just maximize money, rather than minimize regret, the people aiming to match the benchmark make for excellent targets.

  1. Similarly the co-CEO of Dimensional Fund Advisors, an index-ish firm, says, "The moment you say index, you’re telling the world you’re going to be trading on this particular day" -- but "his Austin, Texas-based firm, which manages almost $400 billion, avoids buying stocks immediately before they go into an index. Instead, fund managers purchase them earlier or after the fact," causing tracking error but improving performance.

  2. Oh no not at all. This is "cumulated excess returns," not absolute returns: If the market is down 5 percent, and the index stock is down 3 percent, then that counts as +2 percent. Even that is probably not quite right, but you know what I mean.

  3. From Bloomberg, I see volume on March 20, 2015 of 137.8 million shares, compared with 14.1 million shares per day on average over the previous six months (September 19, 2014 through March 19, 2015) and 692.8 million shares outstanding. 

  4. By the way, the index funds, instead of paying arbitrageurs to supply liquidity, could go source their own by buying in the days leading up to the index add. Some (many?) of them do just that -- see that Vanguard quote. But arguably there are good reasons for some specialization here: Index funds are not well set up to take the tracking-error, etc., risk of buying stocks days before they are added to the index, and may not be well set up generally for tactical trading. So they pay someone else to do it.

  5. Consider the FX-rigging scandal, which had some genuinely scandalous price fixing but also some scandalous-looking anticipation of client orders that was ... fine. Like, signed-off-on-by-the-regulators-and-one-hopes-the-clients fine.

  6. It's China! (Sort of. Minus the indexing.)

  7. Of course, the arbitrageurs who buy ahead of index adds aren't necessarily the same people as the fundamental allocators of capital but, you know, it's all intermediated by the price mechanism, it's all good.

  8. This reminds me of my favorite recurring annual stock-market story: "How you could have turned $1,000 into billions of dollars by perfectly trading the S&P 500." There's a reason no one does it. But they're all underperforming the real benchmark by like 17.9 billion percent.

  9. I mean, some index. It seems socially acceptable to match a range of indexes, or allocations among indexes, though of course there is value in picking the right index (asset class, or computation within an asset class) to match.

  10. You don't even have to call them "decisions": The fund is just mechanically doing what the index says. An S&P 500 index fund couldn't refuse to buy American Airlines, even if it knew that it would go down.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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Matt Levine at

To contact the editor on this story:
Zara Kessler at