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Can You Really Game Index Funds?

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Re: Can You Really Game Index Funds?

#21

Post by evanpw »

tptacek wrote: post #18
KingMob wrote: post #13

Earlier quoted context omitted.

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…

Seconded. This is called the "Grossman-Stiglitz paradox".

There's also a kind of second-order version of market efficiency that says that active fund managers that can actually beat the market will increase their fees until their post-fee returns are the same as everyone else. So even if active _fund managers_ get compensated for making prices more efficient, there's no reason to believe that _fund investors_ will be.

Re: Can You Really Game Index Funds?

#22

Post by cma »

snowmaker wrote: post #20
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.

I haven't offered any, and it would most likely be illegal if it was explicitly going on. And there is likely a wall between the different trading desks (though often the physical embodiment portion of this is literally a cubicle wall the employees can hear each other over). But the orderflow compensation doesn't need to cross over into the retail desk if the ETF itself has enough trading volume to mask some kickback without appearing too egregious.

But price fixing is also illegal--nevertheless, two gas stations across the street at a profitable intersection can engage in it solely through price signal tit-for-tat[1]. This effectively masks intentionality.

Much more fantastical and speculative: machine learning algorithms at both firms could now, or in the future, arrive at this cooperative strategy, even with the only communication being through price signals. Without any human ever even knowingly giving the explicit go-ahead.

[1] https://en.wikipedia.org/wiki/Prisoner's_dilemma#The_iterate...

Re: Can You Really Game Index Funds?

#23

Post by damoncali »

tptacek wrote: post #18
KingMob wrote: post #13

Earlier quoted context omitted.

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…

I don't read him regularly, but I read it as him downplaying index funds as some sort of arbitrary, socially derived benchmark, which just isn't the case. He glosses over - he surely knows this given his background - all the efficient market theory that created the index funds in the first place.

There is a good reason that index funds are very difficult to beat consistently, and it's not because they are copying all the hard work everyone else does for fees. It's because you don't get paid for specific risk.

Re: Can You Really Game Index Funds?

#24

Post by tjradcliffe »

evanpw wrote: post #21
tptacek wrote: post #18

Earlier quoted context omitted.

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…

Seconded. This is called the "Grossman-Stiglitz paradox". There's also a kind of second-order version of market efficiency that says that active fund managers that can actually beat the market will increase their fees until their post-fee returns are the same as everyone else. So even if active _fund managers_ get compensated for making prices more efficient, there's no reason to believe that _fund investors_ will be…

Many years ago I did a comprehensive analysis of Canadian mutual fund returns over about 20 years, and found that the average return per year was dead on the market. The distribuiton of returns was Guassian and had a width of about 1%. I concluded from this that in fact fund managers can beat the market... by precisely amount they pay themselves.

This is evidence for the "second order version of market efficiency" your mention: it was uncanny, and put me into index funds for life (that, and the fact that there was no way of predicting from year-to-year which funds would beat the market the following year.)

Re: Can You Really Game Index Funds?

#25

Post by maaku »

URSpider94 wrote: post #15
cma wrote: post #11

Earlier quoted context omitted.

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.

The majority, sure, but not all. Look at since-inception charts of POGRX, VHT, and BRK.B for example.

Re: Can You Really Game Index Funds?

#26

Post by tempestn »

From what I can see, this article is on point, but is missing an important factor: the risk these "front runners" take. As soon as the announcement is made that a company is joining the index, it's public knowledge. In theory, the expected increase, minus a risk premium, should be priced in immediately. There will likely still be money to be made over the following days until the addition is complete, but it's far from guaranteed, and comes at the expense of reduced diversification. (Which I suppose is another way to say that you're getting paid for providing liquidity, as the article says.) Just because AA went up X% over the 4 days, or whatever, before it joined the index, doesn't mean the next stock will. Perhaps its jump will be overestimated by the HFTs, and retail investors trying to get in in the days following the announcement will end up losing money. Probably not, but it's certainly a significant possibility. So if a person wanted to pursue this active strategy, they would need to manage their risk appropriately. It's not necessarily a bad idea if you enjoy spending your time on that kind of thing, although personally I'd rather index (with a moderate small/value tilt).

Re: Can You Really Game Index Funds?

#27

Post by Tideflat »

maaku wrote: post #25
URSpider94 wrote: post #15

Earlier quoted context omitted.

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.

The majority, sure, but not all. Look at since-inception charts of POGRX, VHT, and BRK.B for example.

However, for a lazy or casual investor discovering the difference between the good managers and the lucky managers is very hard.

Re: Can You Really Game Index Funds?

#28

Post by Lazare »

damoncali wrote: post #23
tptacek wrote: post #18

Earlier quoted context omitted.

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…

I don't read him regularly, but I read it as him downplaying index funds as some sort of arbitrary, socially derived benchmark, which just isn't the case. He glosses over - he surely knows this given his background - all the efficient market theory that created the index funds in the first place. There is a good reason that index funds are very difficult to beat consistently, and it's not because they are copying all…

No, not at all the point Levine was making.

But like tptacek said, you probably need to read Levine regularly to unpack his argument there; it was extremely self-referential.

Re: Can You Really Game Index Funds?

#29

Post by murbard2 »

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…

The company managing the Vanguard fund is owned by the fund holders themselves. It's a closed system and the incentives are aligned.

Re: Can You Really Game Index Funds?

#30

Post by anonu »

tempestn wrote: post #26

From what I can see, this article is on point, but is missing an important factor: the risk these "front runners" take. As soon as the announcement is made that a company is joining the index, it's public knowledge. In theory, the expected increase, minus a risk premium, should be priced in immediately. There will likely still be money to be made over the following days until the addition is complete, but it's far fr…

most of the juice is in predicting the move before the public announcement
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