The recent MSCI index rebalancing has re-ignited an interest in ‘index front running’. Andy Kim and Georgios Oikonomou at Quantitative Research, SG Corporate & Investment Banking examine how index fund managers can minimise the impact of this practice.
Among the obvious benefits index funds have to offer equity investors are low costs and transparency. With a primary objective of replicating the performance of any given benchmark, managers have a much higher incentive to minimise tracking error than to take greater risks to improve returns. Sadly, this is where the perceived transparency and ‘simplicity’ of index investing comes at a cost. If everyone knows which stocks they need to buy (and sell) and when, speculators will obviously attempt to trade the stocks before the passive index funds – the rather crude term for this is ‘index front running’.
Index revision schedules are normally released to the market well before the effective revision date, leaving the route open for speculators. As a result, passive index funds with the tightest tracking error allowances typically choose to wait until the last moment on the effective day of change before trading, leading to inflated prices on the purchase of those stocks being added to the index (and substantially lower prices on those to be removed).
The latest large-scale rebalancing of the Global MSCI indices has once again highlighted how passive index funds, handcuffed by tracking error, can fall prey to pre-positioning by speculators. With the second stage of the MSCI rebalance due in May 2008, without preparation, index funds could again be the victims of ‘front running’.
Quantifying abnormal returns
Société Générale’s most recent analysis quantified abnormal stock returns surrounding both the announcement and implementation dates of the latest MSCI review. In this instance, abnormal returns were calculated as the residual stock performance after removing market and sector effects.
The latest MSCI review was somewhat unusual in that changes in methodology were announced well in advance of the actual confirmation of those stocks to be added or removed from each index. As such, abnormal returns around the revision announcement date were not particularly significant. However, there were substantial share price movements leading up to and after the implementation date.
As an example, Figure 1 shows the performance of the additions and deletions to the MSCI Emerging Market index. The cumulative effect five days prior to execution date amounted to 8%, with most of that effect recorded just one day prior to implementation of the announced MSCI changes.
Figure 2 and Figure 3 summarise abnormal stock price returns for the additions and deletions, in the MSCI developed index, in the days leading up to (and post) the implementation date.
Not unsurprisingly, most abnormal activity seems to be concentrated around the last few trading days prior to implementation. This is in line with our belief that most fund managers wait until the last minute to re-adjust their holdings in order to minimise tracking error. We also observe the sudden reversal of abnormal market activities after implementation.
These abnormal returns were also matched by outsized volume. On the day of implementation, the trading volume for additions and deletions were, on average, four times greater than their normal trading activity.
Recommended Strategies
Know the benchmark index construction methodology and revision rules. This is more difficult than it may sound. Sponsors frequently modify or enhance index rules to cope with evolving market conditions and the constituents themselves are constantly changing as a result of corporate activity and M&A.
Quantify abnormal stock returns surrounding index revision periods. By monitoring the level of abnormal returns in real time and comparing it with theoretical market-impact estimates, fund managers can choose the most optimal point of entry and exit.
For those index fund managers who have the flexibility to engage in market timing, it is clear that extra returns can be captured – or losses minimised – by executing the announced index changes prior to implementation. Our analysis showed that the best way to take advantage of MSCI index changes is to buy additions (and sell deletions) three days before the effective date. Such a strategy has produced significant returns ranging from 1% to over 6%, depending on the index.
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