A Profitable and Legal Way to Game the Stock Market
bloomberg.com
bloomberg.com
I personally know 3 people who run their own money ( <5 million ) who do this as their sole form of income.
Having said that, this isn't exactly easy. You need to know
1) if a stock is going into the index
2) when its going into the index
3) how much the index will buy
4) how much the index buy will affect the price of the stock
the first 3 are trivial for some index funds, though most have rules that allow them some leeway here so there aren't always sure things.
The 4th is where you make your money.
And it isn't like there aren't other's doing this, the article makes it seem much easier than it actually is.
If you play the game theory through you'd realize that if you knew the stock is going into the index then you are probably too late to profit from it as someone else will speculate the stock is going to go into the index the week before and already move the stock.
Funds can't really avoid this, and to be honest they don't really care to avoid it. It doesn't affect them at all, they are just supposed to mimic the index. Though you do start to get into a strange feedback loop whereby the index fund that is supposed to track the index starts to dictate how the index moves, we'll call this the "index inception" effect:)
+1.
The "making hundreds of millions" part made me laugh too. Bet that's news to the index desks.
The very act of noticing that something is a good strategy, and beginning to trade on it, will over time drain away the utility of the strategy, until it is useless or worse than useless.
Tracking indexes is "big", and has some brute simplicity about it, but eventually the market will eliminate that as a viable investment mechanism. (But that won't stop your metaphorical Dad from swearing up and down you need to buy index funds....)
Bogle started the First Index Investment Trust on December 31, 1975. Bogle founded The Vanguard Group in 1974; it is now the largest mutual fund company in the United States as of 2009.
[ source : https://en.wikipedia.org/wiki/Index_fund#Origins ]
The argument isn't that passive index investing is some kind of perfectly optimal investing strategy, it's that it's the most practical strategy for 98% of normal small, individual investors. If you don't have millions of dollars to invest, and you have a real job that prevents you from spending all your time researching investment opportunities, then you are probably better off just buying the market, instead of flailing around paying fees and trade commissions trying to beat the market.
If you believe in the weak form of the Efficient Market Hypothesis, and you are not a professional investor, then you should probably be in index funds.
You're almost always better off with an index than the "HR Director Got a Kickback Growth Fund"
I would like to know how.
I'm not suggesting "anybody can do it" but the study that concludes money managers underperform the market often gets stretched into "nothing beats index funds".
Anecdotally, I spend about 3 hours a week on financial research. I've averaged 13% returns since investing in high school during the 90s.
Nothing wrong with index funds, but the boglehead position isn't axiomatic.
And sometimes a stock might be entering an index but leaving another (e.g., moving from Russell 2000 to Russell 1000), so the net result might be opposite to what you'd naively expect.
So yes, it is possible to make money doing this, but it's not a sure thing.
This does not answer the question about ROI.
Honestly the simplest thing to do is just monitor the big houses and whatever they do en masse do the same. Most giant purchases have to be announced and 10M shares aren't just bought on a whim.
The real diseconomy happens in the Russel indexes. They are rebalanced annually with the methodology for adds/drops announced ahead of time. Various funds that are pegged to Russel are forced to rebalance at this time buying and selling huge baskets in one day. To avoid large stock market movements and capitalize on them traders try to predict the changes to the index and prebuy the rebalance trade. Their actions through the market leading up to the rebalance and agreements to sell the rebalance trade to the Russel pegged funds reduce price swings on the day of the rebalance.
Trading desks that engage in the Russel trade spend the entire year preparing for it, modeling the methodology, acquiring clients for the rebalance trade, and prebuying the trade. Their profit comes from the difference between the closing price (mostly governed by Russel adds/drops) on the day of the trade and the price that they prebought at. Essentially their ability to accurately predict the rebalance add/drops and acquire clients to sell the rebalance trade to. There are desks that make $10s of millions this way on that day. There may be desks that make $100 of millions this way.
PS. I may not have stated it clearly, but funds that are pegged to Russel indexes make agreements with external traders to handle their rebalance trade for them at a fixed bps to the closing price. Traders are able to make money on this because they can take on risk and prebuy the trade; something that the Russel indexed funds can not do.
It might, however, be a good enough reason to side-step this issue and use Total Stock Market (VTSMX) instead of one based on an index that frequently drops/adds stocks.
It's not impossible for someone to squeak some money out of the predictability of an index, but it's not something that makes a ton of material difference with a company like Vanguard.
Some info: http://www.bogleheads.org/wiki/Stock_market_indexing
It would take a bit of effort to grab the data for all stocks entering the S&P for the last (say) 5 years, and then compare how these stocks did between the announcement and the joining of the index, but this data is vital to making the case that there is some market inefficiency here. Since the author doesn't bother to do this work, how can they justify their conclusions?
They can't even manage to get the 'easy route' right (letting someone else do the work). They cite 'one estimate' of a $4.3 billion cost but don't bother to tell use who made that estimate, giving the readers no chance to check its validity.
Lazy, lazy journalism IMO. At least quote your source, Bloomberg!
"Over a course of a year, front-running -- of stocks going into and coming out of indexes -- costs investors in S&P 500 tracker funds at least 0.2 percentage points, according to research published last year by Winton Capital Management Ltd., a quantitative hedge fund that analyzed data from 1990 to 2011. That’s equal to $4.3 billion in lost income in 2014."
That paragraph includes a link to https://www.wintoncapital.com/assets/Documents/WWP_HiddenCos...
That paper is good, it answers all my questions that the original article left unanswered. My dumb mistake for not reading it properly.
This suggests to me that while it was a practical strategy, it isn't so much anymore. With index funds smearing their buys over long enough periods the effect shouldn't even be noticeable.
The Fed report found that there is no long term impact of being chosen to be on an index.
IOW the overhead here is in the noise IMO.
0.2% waste is huge compared to the overhead fee of an index fund. VTSMX fee is 0.17%.
> higher than
You mean "lower than"
Still, if you look at VFIAX it tracks the index perfectly despite front running so it is still nothing to worry about. The amount of money in index funds is large so there is room for a few people to make some money without a big impact. There is some deviation that is significant around the 35 year mark, but do we even know that front running is the cause?
My understanding is that in practical terms weighting shouldn't matter for indexes for the most part since you should only have to buy/sell when funds enter/leave the index (that is the bug). The weight should track without any active trading because it's based on market cap. You buy it and if the market cap increases so does the holding and if it decreases so does the holding. No need for trading.
Now if you want equal weighting among the 500. Well that is an issue. It's one reason not to buy an equal weighted fund.
I know people are thinking of other more problematic indexes than the S&P 500. I don't because I don't buy them so I haven't given a lot of thought to what front running means to them. My investment objective is to hold the entire investable space weighted by market cap (modulo currency risk and home bias) and most indexes play no part of that.
No, because the stock was added to the index on the same day. So the fund is tracking the index, and the index is doing what it said it would do. It's just that they're both buying in an inefficient way that costs more than it might, and others capitalize on that inefficiency.
Also note this is only a problem when the market is mid-term upward or flat. The chances of this type of front running backfiring are pretty high in a bear market. Also, like all forms of arbitrage, there is an upper bound on the number of shares you can do this with before you're dumping more shares on the market than the index funds need. Granted that's probably a big number, but it's not infinite.
https://en.wikipedia.org/wiki/Ugly_Americans:_The_True_Story...
When somebody does something out of the ordinary it's necessarily considered a "game" (read "scam") by the majority establishment.
The reality is that the index is buying the stock because it views it as a good value, meaning that it is currently "under-priced". The index could be then viewed as unethical for "stealing" the shares away from current holders at a lower price than their intrinsic value, unless they were to tell somebody first... like a "frontrunner". In most cases, the largest entity is viewed as corrupt and evil, because it has the means to make the most efficient decisions and capture all the value, but somehow indexes are regarded as altruistic cooperatives.
They're not. S&P is owned by McGraw Hill Financial ($5 billion revenue), CME Group ($3 billion revenue), and News Corp ($33 billion revenue).
Wall Street vs The Ordinary American™ makes for popular news stories.
That's not how all indexes work. The FTSE100, for example, is simply the 100 largest companies on the LSE by market cap[0].
And many indexes (DFA being an exception that I'm aware of[1]) weight companies by their market cap, so the rebalancing trades made by index funds aren't based on value so much as an algorithm.
https://firstlook.org/theintercept/2015/05/07/congress-argue...
You loosen the requirements on how strict the index fund must track. Portfolio managers are incentived to trade smartly if they are ALLOWED to. This is why bulk trades are usually "random" to avoid front-running.
So a solution here is create a competitor to Vanguard who has loose, yet well defined rules that define an index fund and how closely it must track an index. That's it.
EDIT: Others are commenting on index funds have to redefine themselves and add/subtract funds. But that is only the index, not the cause of the price movements. That is looking at it backwards. You need to look towards those moving the prices, like Vanguard, to find a solution.
Actively managed funds exploit inefficiencies in the market, but the more active funds there are, the less their returns through competition. Passive funds are wonderful when the market is efficient, but the more passive funds there are, the more inefficient the market, and the more profit active funds can make. This should create a natural equilibrium between active funds and passive funds where the market should "settle" and returns are optimal for both parties.
Anyone know how to calculate that?
And then of course the value and the cost of high quality information delivered to you in a timely manner is a bit different than staring on CNBC screens.
:)
It's 500 stocks. How many randomly selected stocks do you need to almost equal the performance?
Buying a new entrant on the day it debuts is not required to come very close to matching the index performance.
The article points out that Vanguard “mitigates a good portion” of the risk by gradually building positions over time in stocks.
Problem solved.
> One day, Okul said he wanted to obtain a pwnie for a client
oh kay?
> Building pwnies isn’t itself a crime; anyone can buy a version on the Internet.
hmm... that is false.
Presumably they'd leave a little money on the table because they'd have to guess how much to buy in or sell out, but it'd probably mitigate a good chunk of the loss, right?
Doing it with equities or baskets of equities gets very complicated and if you read the prospective of most ETFs pretty much all of them track the indexes within some margin of error.
Commodity ETFs on the other hand have an underlying asset that will expire or require taking delivery. Most of these ETFs are managed by a group of less than 10 people. They simply do not have the resources to take delivery of an underlying asset. They don't deal with the hassle of storing / taking delivery unless things are really out of whack. Therefore, as a the underlying futures contracts approach maturity, they need to rebalance their portfolio, almost daily, and at minimum once every couple months. In a contango market, it is very easy to front run these funds compared to ETFs that track equity indexes.
I should know, this was my primary trade 4 years ago before quantitative easing killed all volatility in the market.
That being said, the Russell 2000 index is rebalanced only once per year. Opportunities to front run that index with the futures contracts are one of those trades that I miss dearly.