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Can You Really Game Index Funds?

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Re: Can You Really Game Index Funds?

#11

Post by cma »

arielweisberg wrote: post #8

If it were 20+ basis points a year it should show up in the returns and as a failure to track the index. I am not an expert, but that isn't what I see eyeballing a chart of VFIAX over 35 years. It doesn't track perfectly by an amount that does matter, but not .20 basis points a year. Also by this logic total market funds should outperform other indexes by a healthy amount over time. Also maybe not what we are seeing.…

No, the 20+ basis points is considering how the index itself underperforms, because stock prices get bid up just before they get added to the index and then drop back down as the liquidity crisis settles. The index, not just the etfs, take a hit. Vanguard claims to soften this by trading more deliberately and not buying or selling it all at the opening auction on the day a stock gets added or removed, respectively. So you would expect them to be able to do better than the actual index (until you add in all the other management costs/trading costs).

To an extent the amount the ETFs are effective at this lowers the amount the index underperforms, because they (the etfs) are themselves the driver of the liquidity crisis the index is getting subject to. So you would expect some sort of equilibrium, and the claim is therefore to be taken that this equilibrium settles down at of 20+ basis points.

Re: Can You Really Game Index Funds?

#12

Post by tptacek »

Even if you don't care about the index fund "front-running" "scandal", the section starting at "The value of market-making is hard to see and easy to criticize" is critically important to understanding why the markets work the way they do.

As always, Levine is fucking fantastic.

Re: Can You Really Game Index Funds?

#13

Post by KingMob »

solve wrote: post #3

A finance writer that actually knows what he's talking about, and it's here on HN. This is nice.

Ehh, not quite. The author is indeed correct about the market-makers providing liquidity to everyone who wants to purchase on the day a company is added to an index.

But saying "index funds free-ride on the work done by active investors" and then following with "no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital to the right businesses" is FUD.

The value of the market represents the sum total opinion of everyone in it (plus noise), not just the managers of mutual funds losing business to index funds. Frankly, it sounds like the griping of someone telling fund managers that they deserve their fees, but the supposed loss from using index funds described in the original article (~.2%) is still dwarfed by the increased fees of actively managed funds.

Most index fund expenses are around .1-.2%, while most active funds come in at a whole 1-2%. To justify the cost of an actively managed fund, a manager has to not just beat the market, but trounce it. Very, very few can do so for any length of time, and they know it, which is why articles trying to convince people of the virtue of active fund management are constantly written. Unless your manager is as good as Buffett, buy an index fund.

The math is simple, but there's many fund managers out there trying to convince you otherwise.

Re: Can You Really Game Index Funds?

#14

Post by jsprogrammer »

cma wrote: post #9
jsprogrammer wrote: post #7

Earlier quoted context omitted.

So, who loses money in your situation? The person who doesn't realize this is happening?

Shareholders of the ETFs. Again, I'm not saying this specifically actually happens in the case of Vanguard, but all kinds of other conflicts of interest like this happen all the time, and reporters should be ever skeptical, and not just report he-said she-said, "oh Vanguard says they got this covered."

How do they lose though? In higher fund expenses or reduced NAV because the actions reduced the index?

Re: Can You Really Game Index Funds?

#15

Post by URSpider94 »

cma wrote: post #11
arielweisberg wrote: post #8

If it were 20+ basis points a year it should show up in the returns and as a failure to track the index. I am not an expert, but that isn't what I see eyeballing a chart of VFIAX over 35 years. It doesn't track perfectly by an amount that does matter, but not .20 basis points a year. Also by this logic total market funds should outperform other indexes by a healthy amount over time. Also maybe not what we are seeing.…

No, the 20+ basis points is considering how the index itself underperforms, because stock prices get bid up just before they get added to the index and then drop back down as the liquidity crisis settles. The index, not just the etfs, take a hit. Vanguard claims to soften this by trading more deliberately and not buying or selling it all at the opening auction on the day a stock gets added or removed, respectively. S…

And yet, the index itself (not even the funds) reliably beats the overwhelming majority of active traders over almost any time window you care to look at.

Re: Can You Really Game Index Funds?

#16

Post by URSpider94 »

KingMob wrote: post #13
solve wrote: post #3

A finance writer that actually knows what he's talking about, and it's here on HN. This is nice.

Ehh, not quite. The author is indeed correct about the market-makers providing liquidity to everyone who wants to purchase on the day a company is added to an index. But saying "index funds free-ride on the work done by active investors" and then following with "no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital t…

I didn't necessarily take him to be saying that. He is absolutely right that a market that is, quite literally, 100% passive would just sit there and not do anything -- it would just grow as money comes in, but there wouldn't be any relative movement of one share against another.

However, we are in no danger of running out of active traders, so there's no need for anyone to run out and sell their indexed investments to save the free market ...

Re: Can You Really Game Index Funds?

#17

Post by cma »

jsprogrammer wrote: post #14
cma wrote: post #9

Earlier quoted context omitted.

Shareholders of the ETFs. Again, I'm not saying this specifically actually happens in the case of Vanguard, but all kinds of other conflicts of interest like this happen all the time, and reporters should be ever skeptical, and not just report he-said she-said, "oh Vanguard says they got this covered."

How do they lose though? In higher fund expenses or reduced NAV because the actions reduced the index?

On Monday an index is made up of 100% MSFT, and it announces that on tuesday the index will be rebalanced to 100% APPL. The index has ETFs tracking it that are large enough to exhaust the availability of liquidity in both MSFT and APPL during a quick rebalance. Eventually over time the liquidity arrives to correct the mispricing, valuing things based again on underlying fundamentals. Both the index and the shareholders of the ETFs take a hit as the price of MSFT rises (no longer part of the index) and APPL (part of the index) lowers back down to normal, assuming no changes in fundamentals in the meantime.

The ETFs can be smart about it and try and make the trades over time instead of all at once, and Vanguard likely does. This then feeds back in and lowers the amount that the actual index takes a hit. The equilibrium in reality is that both the indexes and the shareholders in the ETFs take a bit of hit.

Re: Can You Really Game Index Funds?

#18

Post by tptacek »

KingMob wrote: post #13
solve wrote: post #3

A finance writer that actually knows what he's talking about, and it's here on HN. This is nice.

Ehh, not quite. The author is indeed correct about the market-makers providing liquidity to everyone who wants to purchase on the day a company is added to an index. But saying "index funds free-ride on the work done by active investors" and then following with "no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital t…

Levine does not think you should invest in actively-managed funds.

The little coda about active management makes more sense if you read him religiously, because this is a schtick of his. Passive management helps most investors. But the market as an entity benefits from active management, because active management makes prices more accurate. This despite the fact that for the most part, contributing to the accuracy of prices comes at the expense of the actively-managed funds.

So without active management, the passive funds would perform more poorly, because their prices wouldn't benefit from the corrections of people trading into them to profit from mispricing.

Re: Can You Really Game Index Funds?

#19

Post by anonu »

This is called the "index rebalancing" trading strategy. Prop desks and hedge funds have known about it for decades. A lot of money is passively benchmarked to many popular indices provided by the likes of S&P, DJ, Nasdaq, etc... One reason people invest in funds that track these indices is because they believe the index provider is a good benchmark for whatever its tracking. For example, the S&P 500 tracks the 500 largest US names. The Nasdaq 100 tracks the 100 biggest (mostly tech-related) names that are Nasdaq-listed. etc... In addition to being a good benchmark, a set of rules (here are S&Ps: https://us.spindices.com/documents/methodologies/methodology...) are published by the index provider that govern how stocks are added and removed to the index. Understanding these rules allows arbitrageurs (aka market-makers) to predict when names are moving before they are announced by the index provider. Since a fair amount of capital is already tracking these indices, the passive indexer will be required to buy/sell the names in the index in the right proportion so as to be properly benchmarked.

Another interesting point is that the Volcker Rule has more or less caused a massive shift of this type of strategy away from US investment banks and into hedge funds. I don't have real data on this - just my observations.

Re: Can You Really Game Index Funds?

#20

Post by snowmaker »

cma wrote: post #4

Order-handling companies pay for "dumb" flow. Vanguard can reduce their outright trading costs to negative by being as dumb about it as possible, and then use these negative costs to artificially lower their reported fees. Just because Vanguard claims to be smart about it, doesn't mean necessarily they actually are incentivized to be smart about it or actually are in practice. People can still judge them by how close…

Is there any evidence that Vanguard gets kick-backs in return for their dumb order flow?

I would think that would be a HUGE scandal if it were true and ever came out.

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