Know Your Enemy

Here’s an investing adversary that any index fund or ETF owner should be aware of. Passive funds create opportunities for others when their underlying indices are rebalanced, Jerome Nunan, client portfolio manager at Aviva, tells Paul Amery, editor of Jerome, you look after Aviva’s Index Opportunities fund. How does the fund work?

Nunan: The fund exists to take advantage of a market inefficiency that seems to be persistent. We aim to capitalise on the forced selling and buying activity amongst passive funds that occurs as a result of the regular rebalancing of equity indices.

Interestingly, although hedge funds and investment bank proprietary trading desks devoted a lot of capital between 2003 and 2007 to exploiting such anomalies, they still weren’t arbitraged away. We attribute this to the sheer weight of money that’s been going into passively managed funds, whether ETFs or other index-tracking strategies.

And now that a lot of those hedge funds and prop traders have quit the market, we actually feel that there are more opportunities than before, although markets have become more volatile as well.

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Nunan: Usually we put on a position, whether long or short, either before the date of announcement of an index rebalancing, or on the announcement day itself. We then typically close the trade in the run-up to the effective rebalancing date.

We do our own modelling of which securities might join or be excluded from an index. As we run £13 billion of index funds ourselves, we’re aware of some of the market inefficiencies and we understand how index inclusions and exclusions are determined. Do stock prices move much between the announcement date of an index rebalancing and the effective rebalancing date? If so, isn’t this surprising? Shouldn’t prices adjust immediately after a rebalancing announcement is made?

Nunan: Yes, the largest opportunities to generate “alpha” occur between the announcement date and the effective rebalancing date. The reason for this is that if passive fund managers trade before the effective date they risk creating tracking error. So, even if it’s often better from a price perspective to buy the stocks that are being included in an index earlier rather than later, index fund managers have no incentive to do so. The same applies in reverse for deletions.

Usually, index fund managers end up making their trades in the stocks being added or deleted at the closing price on the last trading day before the effective date. In practice this means that by far the largest alpha opportunity for other investors occurs in the last 24-48 hours before the effective date, when the volatility is typically greatest. If index funds are throwing up such opportunities to make money for other investors, does that mean they are naturally inefficient or even a bad investment idea?

Nunan: I wouldn’t say that. People buy index-tracking funds for all sorts of reasons and the passive versus active debate has been going on for many years. Passive investment vehicles give people a certain exposure to the market and one that’s easy to understand. However, inherent in them is an inefficiency arising from the way passive funds are run, and specifically the focus that their managers have on minimising tracking error. What indices do you focus on?

Nunan: When launching the fund we deliberately didn’t constrain ourselves in the choice of indices. There are a lot of opportunities being thrown up in emerging markets now, for example. We allow ourselves to be guided by the market and see where possibilities to make money arise. When it comes to rebalancing, are some indices easier for you to capitalise on than others?

Nunan: Yes, certainly. As an example of an index where the rebalancing strategy is hard to predict, take the S&P 500. In most other capitalisation-weighted indices it’s relatively easy to forecast which stocks are coming in and which are leaving. But although the S&P 500 is capitalisation-weighted for the stocks included, the selection policy is not based on company size alone. Constituents are chosen by the S&P Index Committee based on market size, liquidity, and sector representation. And which indices do you expect to throw up the greatest opportunities over the next year?

Nunan: The MSCI World, because of the sheer number of stocks that are included and excluded, and the Russell 3000, for the same reason. Having said that, the US market is a lot more transparent and the market is more efficient there, so the opportunities are probably smaller in absolute terms.

Having said that, it’s harder work to hedge yourself when an index like the MSCI World is involved, as there’s no related futures contract, for example. But there are clear inefficiencies and usually plenty of liquidity to allow trades to take place.

For the same reasons – inefficiency, less transparency – Asian and emerging markets are throwing up an increasing number of opportunities as well. What about indices that are compiled by criteria other than cap-weighting? Can you capitalise on the rebalancing of model-driven benchmarks, such as RAFI’s fundamental indices, for example?

Nunan: In theory, we probably could. We operate our own versions of fundamental indices, so we probably have a reasonable idea of what firms like RAFI or GWA are doing with their own benchmarks.

In practice, we look at the size of the opportunity – how much money, in other words, is being managed against the relevant passive benchmark. The more money there is following the index, the greater the opportunities that are likely to be thrown up.

And in fact there are so many easily accessible pockets of alpha available for us to exploit in more widely used indices that we haven’t yet felt the need to look at some of the more esoteric ones. Your fund takes both long and short positions in stocks involved in index rebalancings. What’s the split between the two?

Nunan: Generally we have a greater degree of confidence in trades that involve stocks coming into indices than those involving stocks leaving.

So we have an inherent bias towards long positions. That said, because we aim to be market- or beta-neutral we hedge any net positions, whether long or short, with a market hedge.

  • Luke Handt

    Luke Handt is a seasoned cryptocurrency investor and advisor with over 7 years of experience in the blockchain and digital asset space. His passion for crypto began while studying computer science and economics at Stanford University in the early 2010s.

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