Index Changes Getting Harder to Exploit By Will McClatchy January 8, 2002

In the current environment, changes in indexes appear to be less vulnerable to profit-taking attacks by active traders than in the past.

"Trading on index changes is not necessarily the smart thing to do these days," said Sandy Rattray, derivatives and trading research manager at Goldman Sach & Co., before an audience of pension fund managers at last month's Super Bowl of Indexing, where the cost of index changes was a major topic of concern.

From the S&P 500 to the MSCI EAFE, indexes have at times offered an easy target for active traders. In the case of the S&P 500, these traders often buy a stock recently annouced for promotion into the index or sell a stock due for demotion before the "effective day" the index change officially takes place, when swarms of institutional index investors traditionally piled on orders. This pushes up prices for indexers and lowers their returns.

The impact of being added to the S&P, and thus the benefit of buying the stock in hopes of a spike, declined steeply during 2000 and 2001, Rattray's group found. "Mechanical strategies have started to carry a lot of risk," he said. For most of last year an investor who waited one day to add a stock to a portfolio mimicking an index change did beter than the investor who added it on trading day.

Furthermore, the market still doesn't know an addition will hapen before announcement, as evidenced by lack of unusual price movement prior to announcement over the last 10 years. Security on announcements is apparently good, at least judging from market results.

Surprisingly, the most popular measure of demand, the projected number of days' volume of orders for a stock that is being added or deleted from an index, is not a good predictor for that stock's performance. This number is calculated as an estimate based on the known amount of assets tracking that index. If there is impact, it will mostly be felt between the announcement and trading day. Rattray feels it is hard to poach on index changes because "a very wide range of players emerge who are willing to buy and sell" at prices that may diverge from previous prices.

The best two indicators of market impact are the recent performance of the stock and the expected weight of the stock in the index at addition. Stocks that have recently outperformed have less impact, and stocks that will occupy a relatively large weight have significant impact.

In the case of MSCI international indexes, their switch from capitalization weighting to float weighting this year was widely expected by many to further punish institutional index funds that had to rebalance significantly to stay with them. The concern was palpable this year among large pension fund managers, since hundreds of billions of pension fund dollars follow MSCI international indexes.

Apparently the final, official transition of these enormous portfolios to float weighting created no exploitable market impact. Rattray said his group found little exploitable price movement was found during official float transition periods. The prevailing wisdom is that MSCI spaced out its index rule changes over so many months that arbitrageurs found it hard to profit without exposing themselves to fundamental market risk. Others still maintain that there still is market impact, even if it was spaced out, and that in any case much of the damage was done in previous years as many cap weighted portfolios underperformed float weighted ones over recent decades.

Long gone are the days when a large number of active managers could claim they were beating MSCI's dominant EAFE index simply by sidestepping obviously overvalued Japanese equities, a successful ploy for over a decade in the late '80s and early '90s. Now even the shorter-term opportunities are disappearing.