Index Effect Raises New Concerns

December 05, 2013

The rising popularity of smart beta could cause a drag on benchmark performance.

[This article previously appeared on our sister site,]

In the 1970s an economic advisor to the Bank of England defined a rule that is still used. According to Charles Goodhart, “when a measure becomes a target, it ceases to be a good measure”.

Goodhart’s law was widely cited in the 1980s, when the UK government tried to control inflation by targeting the money supply. But policymakers found that as soon as they focused on a monetary aggregate such as M-3, the measure started to misbehave.

The law is familiar to those in the indexing business, too. Investors have long been aware of the distortions that can arise when large volumes of money track or reference a particular measure of the stock market.

This “index effect” can cause substantial swings in the prices of stocks being added to or deleted from a popular benchmark. In 2010 fund manager Aviva even set up an “Index Opportunities fund” to take advantage of such rebalancing trades.

In a presentation, Aviva showed examples of the effect: a near-10 percent rise in the price of power generator Aggreko between the date of the announcement of its addition to the FTSE 100 index in 2009 and the actual index change, two weeks later; and substantial late-day price jumps in new MSCI index constituents Lanxess and Bekaert on 30 November 2010, one of MSCI’s semi-annual rebalancing dates.

Index firms and the managers of index-tracking funds have developed a variety of strategies to fend off other market participants—typically, hedge funds and high-frequency traders—who try to “game”, or exploit, such predictable, index-related buying and selling patterns.

At index providers, the most common approach is to give as much advance warning as possible of index changes, allowing the managers of passive funds to stagger their purchases and sales, rather than conducting trades at a single point in time.

However, some index designers take the opposite view. Fund manager Ossiam, which has worked with external index providers to develop a range of minimum variance strategies, only releases details of its indices’ new portfolio weights a day ahead of the rebalancing date, and to a limited group of market participants. The new index weightings are disclosed on Ossiam’s website two days after each monthly rebalancing.

“It’s important that information is not disclosed to too many people at the same time as you want to avoid front-running,” Ossiam’s CIO, Fabien Dornier, told

“All indices—whether capitalisation-weighted or smart beta—are prone to this phenomenon,” said Dornier. “Some index providers release information on the stocks entering and exiting the benchmark a week or two in advance of the rebalancing date. We prefer to keep the time frame shorter. We also filter out the smaller and less-traded stocks to focus on the larger, liquid names whose prices are less subject to manipulation.”

Another approach is to make rebalancing events less predictable.




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