The rising popularity of smart beta could cause a drag on benchmark performance.
[This article previously appeared on our sister site, IndexUniverse.eu.]
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 IndexUniverse.eu.
“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.
For its widely followed Global Investable Market Index series, MSCI chooses to disguise the dates on which index changes occur, selecting each semi-annual rebalancing date randomly from a window of ten days.
This type of rebalancing helps prevent front-running, although it comes at the expense of simplicity and transparency.
When altering the composition of tracker funds to reflect index changes, portfolio managers also face a choice between two options, neither of which is perfect: aim to buy and sell stocks at the prices used in the actual rebalancing, even if this causes adverse price movements; or trade ahead of or after the index change point in an attempt to minimise market impact, risking tracking error between a fund and its index.
“Most mandates require managers to replicate the return and risk characteristics of the index,” a fund manager at one of the largest index-tracking firms told IndexUniverse.eu.
“You can take that literally, to mean every second of each day, requiring a mechanistic approach to replicating index changes, or you can accept that you need to track over time, meaning that you can take a different approach.”
The type of index being rebalanced can also affect the fund manager’s choices.
“In some stock markets—for example, Germany’s XETRA system—you have a closing auction every day. If you are a fund manager wishing to rebalance an index-tracking portfolio you can guarantee obtaining the price used in the index by participating in the auction,” Konrad Sippel, head of business development at index provider STOXX, told IndexUniverse.eu.
“But if a stock market’s closing price is that of the last trade, and that determines how the index rebalances, it may not be possible for every market participant to execute deals at the same price,” said Sippel.
In practice, most fund managers now prefer to avoid trading at the actual point of index rebalancing, particularly outside the US.
“Index-tracking fund managers in Europe have traditionally taken a pragmatic approach to managing index changes as a way of minimising costs,” Richard Hannam, head of global equity beta solutions at State Street, told IndexUniverse.eu.
“If you conduct all your rebalancing trades at the closing prices on the effective date of the rebalancing, you’re automatically going to underperform after costs,” said Hannam.
Another way for the managers of index funds to offset costs is to outsource rebalancing trades to third parties such as investment banks’ “delta one” desks, who often offer to guarantee outperformance against the index over the rebalancing period, in return for a fee or a share of the upside.
“It’s important to manage rebalancing trades in the most efficient way to reduce some of the associated costs,” Keshava Shastry, head of ETP capital markets at Deutsche Asset and Wealth Management, told IndexUniverse.eu.
“Due to supply and demand in the market, sometimes it is possible to earn extra return during the index rebalancing by outsourcing it to suitable execution brokers. Just like securities lending, as long as this is conducted within the fund guidelines, it’s consistent with the fund manager’s fiduciary duty,” said Shastry.
But the existence of rebalancing-related outperformance fees for fund managers or banks' trading desks is problematic for so-called “smart beta” indices in particular, says one fund manager.
Smart beta indices embed an investment strategy and, as a result, generate more buying and selling trades than traditional, capitalisation-weighted indices. Smart beta index turnover of over 50 percent a year is common, while capitalisation-weighted index turnover may be ten times less. Smart beta indices often also deal in relatively illiquid stocks, for which the costs of trading are higher.
“Asset managers replicating a smart beta index are incentivised to push prices at the close of the index higher for the stocks they are forced to buy, and lower for the stocks they have to sell, both of which are against the interest of the end-investor,” said Mark Voermans, senior strategist at Dutch pension fund manager PGGM.
Voermans hinted at overcrowding in smart beta index strategies at the recent Inside Indexing Europe conference. In his presentation, he showed that his firm’s internally managed minimum variance fund had outperformed minimum variance indices from MSCI and FTSE by between 4 and 6 percent over the last three years.
PGGM chooses to construct minimum variance portfolios itself, rather than buying a pre-packaged index version of the strategy.
“Investors should be careful in implementing a smart beta replication strategy and should at least allow their fund manager leeway to avoid doing exactly what the index suggests,” added Voermans. “The index should be used as a reference point, a benchmark, not as the strategy itself.”
Assets in funds following a minimum variance approach, many of which track indices, have expanded five-fold since 2010, according to research from investment bank Nomura.
Investors concerned about others gaming their index funds’ buying and selling decisions can take some comfort from one piece of evidence. In October Aviva closed its Index Opportunities fund, having undershot its performance targets. For Aviva, exploiting the index effect proved harder than identifying it.
But as higher-turnover, smart beta strategies gain in popularity, some long-voiced concerns over the impact costs of indexing have resurfaced.