A Possible Antidote to Index Front-Runners: Secret Indexes By John Spence February 8, 2002

One of the biggest knocks against index funds is that they foster the so-called "index effect." This occurs when a stock is added to or removed from a well-known index like the S&P 500 or Russell 2000, and it is costly to investors. The company that is being added to the index experiences an artificial price spike as index funds snap up shares. A cottage industry of speculative traders has sprung up that attempts to anticipate and front-run index additions. The theory is that rigid index funds end up paying more for the added company shares they must buy, and investors suffer lowered returns.

The solution? According to Gary Gastineau, managing director at Nuveen Investments, the answer is closet index funds, and he's not talking about high fee active funds that simply follow indexes. No, he's talking about something more
covert - a clandestine index fund if you will. Gastineau envisions "fund friendly" indexes that would not publicly announce upcoming index changes; instead only index fund managers would be privy to pending index additions and deletions.

"Disclosure is not appropriate, necessary or desirable for a fund-specific index," writes Gastineau in an upcoming article. He points to the S&P 500 and the small-cap Russell 2000, which rebalances only once a year in June, as the favorite targets of index front-runners. David Blitzer, head of the committee in charge of determining who enters and exits the S&P 500, has stated that a stock gains 8% over the week or so between when a change is announced and when it is implemented.

However, not everyone in the industry is sold on the idea of index funds, or more likely exchange-traded funds, tied to secret benchmarks. According to these industry professionals, Gastineau is addressing a problem that was rampant in the late 1990s but is on the road to being fixed. Index fund managers (no, they're not monkeys) are learning how to handle price squeezes during rebalancings and are becoming less predictable in how they trade. Certainly, when one envisions index fund managers simply putting in market-on-close orders on the day of an index rebalancing there is the danger of being front-run.

Another improvement is coming from index providers, who are moving their indexes from market capitalization to free-float weighting. In cap-weighted indexes, a company's weight in an index is determined by the total number of company shares. Float weighting takes into account only those shares that are available for purchase on the open market, which excludes shares held by company insiders and governments, for example. The S&P 500 is one of the only largely followed equity indexes that hasn't moved to float weighting. Gastineau says it's unlikely the S&P 500 will change to float weighting because of the chaos the transition would create in the U.S. market.

"Cap-weighted, rather than float-weighted, indexes are a problem because you have price squeezes because there aren't enough shares to go around when a company goes into an index," says Wayne Wagner, who helped develop Wells Fargo's first index funds and is currently head of the Plexus Group, a Los Angeles-based transaction process adviser to investment managers, plan sponsors, and brokerage firms. He also believes it's getting more and more difficult to exploit the index effect.

"For a while it was easy pickings, but only as long as only a few people knew about it," said Wagner. "If enough people try to jump the index change, they'll overshoot."

According to Nuveen's Gastineau, index fund managers with miniscule tracking error that slavishly follow indexes are the biggest problem. They foster buying frenzies around index rebalancings that create dramatic index effects. But not all index funds are created equal.

Take Vanguard index fund guru Gus Sauter and his team, who practice an aggressive style of indexing that involves buying futures and other techniques. Vanguard managers are compensated on how well they track an index and how much value they can add to shareholders by picking up a few basis points over the index. Although Sauter must track the index to a reasonable degree, he does have some leeway in terms of buying stocks shortly before or after index inclusion, although it's usually a matter of hours, not days.

The consistent outperformance of the Vanguard Small-Cap Index Fund relative to its benchmark lends credence to Gastineau's assertions about the opportunity for gaming the Russell 2000 rebalancing. However, you won't hear investors in this index fund complaining.

In June 2001, Vanguard Small Cap was up 4.19%, while the Russell 2000 was up 3.45%, a phenomenon Morningstar analyst Scott Cooley says he notices almost every year.

Steven Schoenfeld, head of international equity products at Barclays Global Investors, says there is a gray area between active and passive management as far as dealing with an index rebalancing. In short, you don't want a monkey running your index fund because indexes are transparent and how a manager trades affects the bottom line. However, Schoenfeld believes it is possible for index fund managers to overcome index effects without the aid of nondisclosed indexes.

"Innovations in indexing will accelerate, and the line between index and active will continue to blur," said Schoenfeld.

It remains to be seen whether the fund industry and regulators will embrace Gastineau's rather unconventional solution to dealing with the index effect and index front-runners. However, secret indexes would necessarily create a cozy relationship between the index provider and the fund manager. In the wake of Enron's collapse, any situation that could create a potential conflict of interest will indeed be scrutinized very closely.