'Buffering' Investors from Index Effect

December 29, 2003

Index industry practitioners debate the optimal strategies to reduce the hidden costs of passive investing.
Indexing is a powerful investment strategy primarily because investors gain diversified exposure to asset classes at rock bottom cost and with consistent performance.  Simplicity and portfolio transparency are two more reasons why an estimated 35% of institutional assets in the U.S. are indexed.  However, the success and popularity of indexing has created 'hidden costs' that index providers must continually seek to reduce through creative and unique benchmark methodology solutions.   This is particularly the case for 'flagship indexes' - the most popular indexes, which have billions of dollars of index-based assets tracking them.

During early December's Superbowl of Indexing Conference in Phoenix, industry practitioners presented and debated the merits of their differing approaches to combat the common problems they face.

Hidden Cost #1 - Those Pesky Front-Runners

When an index is rebalanced, or when companies enter or leave during a reconstitution, index funds and ETFs must follow suit - or endure undesirable index tracking error.  Index fund holdings are transparent; benchmark providers make index constituents available to the public.  Most indexes use objective rules-based methodologies, which means that hedge funds and speculators can predict index fund trades with a good deal of accuracy before the fact.  Indexes that use a committee format, like the S&P 500, are more difficult to forecast - although S&P publicly announces index additions and deletions before they are actually implemented.

Because of their transparency, index funds are vulnerable to 'front runners' that can bid up the price of a stock about to be added to an index, or short stocks that are due to be booted from the benchmark. On the other hand, actively managed stock funds, with their infrequent disclosure requirements, are under no constraint to tip their hand in advance of a trade.

"A stock price normally jumps at the moment it is announced that the stock will enter an index like the S&P 500," said Gus Sauter, Chief Investment Officer at indexing giant the Vanguard Group.  "Hedge funds leverage themselves heavily to take advantage of this 'index effect.' Hedge funds build up their inventory of the added stock to dump on index funds."

The bottom line is that index investors can suffer lower returns as a result of this predatory - yet perfectly legal - practice.

"Front runners damage indexers," said Jim Creighton, Chief Investment Officer of Northern Trust Global Investments. "An estimated $25 billion [25 basis points a year] was lost by S&P index funds to front runners in the past decade," he claimed during a panel discussion. (1)

During an index reconstitution, index funds are essentially playing a high-stakes game of poker against front running adversaries- but with their cards turned over for all to see.  The problem is even more pronounced in the small-cap arena, where many of the stocks are illiquid.

"It's all about a balance between transaction costs and index tracking error," said Sauter, who is widely regarded as one of the game's best players.

"Indexers have an advantage over traders because indexers know when they themselves will trade, but battling front runners invariably results in tracking error," said Creighton.

Essentially, the best way for index funds to combat front-runners is to be unpredictable.  This fact was evidenced when MSCI ran parallel indexes during the transition to free float (discussed more below) a few years ago.  Many indexers made the switch early, so they weren't there at the later transition date, and front-runners found themselves in the middle of a bloodbath.

Hidden Cost #2 - Turnover and Buffer Zones

Traditionally, when stocks move back and forth between small-, mid-, and large-cap indexes they do so in an 'all or none' fashion.  Therefore, index funds are required to sell or buy a stock within a short time period, which leads to turnover.  For example, the small-cap Russell 2000 index reconstitutes only once a year, which Russell says provides the optimal balance between representation and turnover.

However, some index providers and industry practitioners are moving to 'buffer zones' to cut down on unwanted turnover.  Rather than a definite line in the sand, some indexes - such as the new MSCI U.S. equity indexes - have multiple thresholds.

"A buffering system reduces turnover and allows for more frequent reconstitution, so you can have it both ways," said Mark Sladkus, a consultant to MSCI. "Also, buffers more closely mirror the investment process of active managers."

(For more information about buffers and optimal index practices, please see Gus Sauter's article Index Rex in the 2nd Quarter, 2002 issue of the Journal of Indexes.)

Hidden Cost #3 - The Free Float Question

Most equity indexes are market-capitalization weighted - a stock's proportion in an index is determined by the price of a share multiplied by the total number of shares outstanding.  Increasingly, though, indexes also account for shares that are not available in the open market with so-called 'free-float' weighting.  This is because in some cases large chunks of company stock are not available on public markets.  For example, a significant portion of Microsoft was held by top company executives like Bill Gates, while a large amount of stock in some countries is owned by the government there.

Therefore, 'liquidity crunches' can occur when these stocks are added to an index, and passive funds end up paying more because there are not enough shares to go around.  Again, index investors suffer reduced returns.

To combat this problem, most equity indexes have moved to free-float weighting - a company's weight in an index is determined by only the shares available on public markets.

"Without free float, you're not capturing the entire opportunity set.  However, free float is not a free lunch - it results in more potential turnover, and it's not an exact science.  Free float is important, but not exactly a critical issue, and it matters more in small-cap indexes," said Sladkus.  "The small-cap arena is where free float matters most, since only 70% of stock is publicly available in small-cap - the percentage is much higher in large- and mid-caps."

International and global indexes have also focused extensively on the free-float issue, and all the major developed market and emerging market indexes are now float-adjusted. This can be an important benefit for index-based portfolios investing in the smaller developed and emerging markets.

The 'free float question' has been one of the most controversial topics among index providers the past few years.  "An overwhelming majority of asset managers want free float, and index managers must provide what their clients want," said Carl Beckley, head of research for the FTSE indexes. 

In particular, many institutional investors have called for the S&P 500 to move to free-float weighting.  S&P isn't completely sold on the idea yet, and released a concept paper recently that argued against moving to free float.

"Free float adjustment is under review, and we'll make a decision in January 2004," said David Blitzer, chairman of the S&P 500 index committee.  "Our research found that free float adjustment makes little or no difference in S&P 500 performance or risk.  It might affect transaction costs and liquidity, but it's difficult to measure."

What is clear from both the debate on this issue, and from the various solutions being implemented by both index providers and index fund managers, is that the 'index effect' - while remaining a major issue for concern and focus by market participants - may never again be a simple, linear situation.   As befits a dynamic market and industry, it's become more like multivariate geometry.


(1) Creighton expounds further on the "Wealth Erosion" from index changes in a sidebar in the forthcoming book, Active Index Investing, to be published by John Wiley & Sons in this Spring.


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