10 ms·

Can You Really Game Index Funds?

115 points by zweiterlinde 11y ago

kqr2 11y ago
Reference to hn thread discussing the original article A Profitable and Legal Way to Game the Stock Market https://news.ycombinator.com/item?id=9844686 https://news.ycombinator.com/item?id=9844686
solve 11y ago
A finance writer that actually knows what he's talking about, and it's here on HN. This is nice.
- arbitrage314 11y ago
  Agreed! Very nice and rare to see on HN! :)
- KingMob 11y ago
  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.
  - URSpider94 11y ago
    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 ...
    - KingMob 11y ago
      Hmm, well, that wasn't the impression I got. Given the venue and audience, that part of the article felt more like it was giving fund managers the talking points they need to lure in unsavvy investors.
  - tptacek 11y ago
    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.
    - evanpw 11y ago
      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.
      - 11y ago
- mikeyouse 11y ago
  There should be a bot that posts everything that Matt Levine writes to HN -- It's such great quality writing from someone deeply knowledgeable in finance. Another good article where he discusses the Goldman software developer who 'stole' company code: http://www.bloombergview.com/articles/2015-07-07/goldman-coder-goes-free-but-insider-trader-stays-in-jail http://www.bloombergview.com/articles/2015-07-07/goldman-cod...
cma 11y ago
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 they track the index, but that is reported separately from fees, which are all a lot of current and future retirees look at after having fees fees fees drilled into their heads. And the indexes themselves take a hit, so you need to adjust for that with a much more complicated measure. They can effectively launder bad (or even good) tracking of the index into lower reported fees, by letting the order handlers profit on the inanity (and kickback via order-flow payments), allowing the fund managers to give themselves higher compensation without commiserate alarming fees. To what extent, if any, do they actually do this? Do they report their income from paid order-flow in the fund prospectuses? Do they break it out by the managed funds, vs retail flow from their clients? Do they get major concessions to their retail trading costs in tacit exchange for being dumb with their etfs?
- iaw 11y ago
  Could you elaborate or provide more reference materials on "dumb" flow?
  - cma 11y ago
    http://www.reuters.com/article/2010/12/17/us-markets-dumb-money-idUSTRE6BG2H320101217 http://www.reuters.com/article/2010/12/17/us-markets-dumb-mo... It is basically order flow that often blindly takes liquidity. Traders pay to get it, execute it prop at the best price (though they also can dump straight to the market without taking it prop if it isn't behaving dumb enough). Then they resell the position on the market at a more deliberate pace, providing liquidity (which lets them capture the spread, and lets them earn kickbacks from exchanges that pay for liquidity). Or they match the positions against future dumb flow coming in on the other side.
- jsprogrammer 11y ago
  So, who loses money in your situation? The person who doesn't realize this is happening?
arielweisberg 11y ago
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. Granted total market funds invest in something that is different from what other indexes track.
- cma 11y ago
  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.
  - URSpider94 11y ago
    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.
    - maaku 11y ago
      The majority, sure, but not all. Look at since-inception charts of POGRX, VHT, and BRK.B for example.
      - Tideflat 11y ago
tptacek 11y ago
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.
- 6stringmerc 11y ago
  You know what's easier to criticize? Manipulating LIBOR and nobody going to jail. The downstream effects of instruments pegged to LIBOR is staggering, well, would be if the industry / reglatory agencies actually did anything of merit. Remember, the main rationalization for Bernie Madoff's unbelievably consistent returns was that he was front-running, and fund after fund after fund after fund lined up to give him money. Besides, front-running isn't really where the big money is anyway. Insider trading is way, way more profitable from an individual standpoint.
anonu 11y ago
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-sp-us-indices.pdf 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.
tempestn 11y ago
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).
- anonu 11y ago
  most of the juice is in predicting the move before the public announcement
  - tempestn 11y ago
    Likely true. Also not without risk of course, since the chance of a stock getting added should also be priced in. If you're better than the "market" at predicting these things, you'll likely do well. I don't expect I am.
kasey_junk 11y ago
More commentary from an ex-index arb trader: http://kiddynamitesworld.com/where-bloomberg-discovers-that-large-orders-have-market-impact/ http://kiddynamitesworld.com/where-bloomberg-discovers-that-...
meeper16 11y ago
How about a historical back-test? Should be simple enough.
danieltillett 11y ago
Are there any index funds that track the entire market? Wouldn’t investing in all companies solve the problem of index tracking?
- p1mrx 11y ago
  Yes, it's called a Total Stock Market Index Fund, and they are quite popular. There's really no reason to invest in the S&P500 anymore.
  - danieltillett 11y ago
    That makes sense. I am surprised why anyone would want to choose S&P500 in this case.
    - Tomte 11y ago
      Because most of us don't live in the United States. Good luck finding a total market index fund elsewhere.
- atinoda-kestrel 11y ago
  > Are there any index funds that track the entire market? Wouldn’t investing in all companies solve the problem of index tracking? Yes, there are funds that try to match the entire market. Vanguard runs a couple "total market" indices (VT and VTI, for example), and there are more. But that's not to say that they actually invest in the entire market. They don't; they use sampling to try to match the performance of the thing they index. (Vanguard, at least, gets very very close to this...) Disclosure: I am invested in in VTI.
jackgavigan 11y ago
Matt Levine stands out amongst journalists and commentators as someone who actually knows what he's writing about because he's been there, done it, and now wears the t-shirt when he's changing the oil on his car.

115 points by zweiterlinde 11y ago

kqr2 11y ago

Reference to hn thread discussing the original article A Profitable and Legal Way to Game the Stock Market https://news.ycombinator.com/item?id=9844686 https://news.ycombinator.com/item?id=9844686

solve 11y ago

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

arbitrage314 11y ago
Agreed! Very nice and rare to see on HN! :)
KingMob 11y ago
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.
- URSpider94 11y ago
  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 ...
  - KingMob 11y ago
    Hmm, well, that wasn't the impression I got. Given the venue and audience, that part of the article felt more like it was giving fund managers the talking points they need to lure in unsavvy investors.
- tptacek 11y ago
  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.
  - evanpw 11y ago
    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.
    - 11y ago
mikeyouse 11y ago
There should be a bot that posts everything that Matt Levine writes to HN -- It's such great quality writing from someone deeply knowledgeable in finance. Another good article where he discusses the Goldman software developer who 'stole' company code: http://www.bloombergview.com/articles/2015-07-07/goldman-coder-goes-free-but-insider-trader-stays-in-jail http://www.bloombergview.com/articles/2015-07-07/goldman-cod...

cma 11y ago

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 they track the index, but that is reported separately from fees, which are all a lot of current and future retirees look at after having fees fees fees drilled into their heads. And the indexes themselves take a hit, so you need to adjust for that with a much more complicated measure. They can effectively launder bad (or even good) tracking of the index into lower reported fees, by letting the order handlers profit on the inanity (and kickback via order-flow payments), allowing the fund managers to give themselves higher compensation without commiserate alarming fees. To what extent, if any, do they actually do this? Do they report their income from paid order-flow in the fund prospectuses? Do they break it out by the managed funds, vs retail flow from their clients? Do they get major concessions to their retail trading costs in tacit exchange for being dumb with their etfs?

iaw 11y ago
Could you elaborate or provide more reference materials on "dumb" flow?
- cma 11y ago
  http://www.reuters.com/article/2010/12/17/us-markets-dumb-money-idUSTRE6BG2H320101217 http://www.reuters.com/article/2010/12/17/us-markets-dumb-mo... It is basically order flow that often blindly takes liquidity. Traders pay to get it, execute it prop at the best price (though they also can dump straight to the market without taking it prop if it isn't behaving dumb enough). Then they resell the position on the market at a more deliberate pace, providing liquidity (which lets them capture the spread, and lets them earn kickbacks from exchanges that pay for liquidity). Or they match the positions against future dumb flow coming in on the other side.
jsprogrammer 11y ago
So, who loses money in your situation? The person who doesn't realize this is happening?

arielweisberg 11y ago

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. Granted total market funds invest in something that is different from what other indexes track.

cma 11y ago
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.
- URSpider94 11y ago
  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.
  - maaku 11y ago
    The majority, sure, but not all. Look at since-inception charts of POGRX, VHT, and BRK.B for example.
    - Tideflat 11y ago

tptacek 11y ago

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.

6stringmerc 11y ago
You know what's easier to criticize? Manipulating LIBOR and nobody going to jail. The downstream effects of instruments pegged to LIBOR is staggering, well, would be if the industry / reglatory agencies actually did anything of merit. Remember, the main rationalization for Bernie Madoff's unbelievably consistent returns was that he was front-running, and fund after fund after fund after fund lined up to give him money. Besides, front-running isn't really where the big money is anyway. Insider trading is way, way more profitable from an individual standpoint.

anonu 11y ago

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-sp-us-indices.pdf 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.

tempestn 11y ago

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).

anonu 11y ago
most of the juice is in predicting the move before the public announcement
- tempestn 11y ago
  Likely true. Also not without risk of course, since the chance of a stock getting added should also be priced in. If you're better than the "market" at predicting these things, you'll likely do well. I don't expect I am.

kasey_junk 11y ago

More commentary from an ex-index arb trader: http://kiddynamitesworld.com/where-bloomberg-discovers-that-large-orders-have-market-impact/ http://kiddynamitesworld.com/where-bloomberg-discovers-that-...

meeper16 11y ago

How about a historical back-test? Should be simple enough.

danieltillett 11y ago

Are there any index funds that track the entire market? Wouldn’t investing in all companies solve the problem of index tracking?

p1mrx 11y ago
Yes, it's called a Total Stock Market Index Fund, and they are quite popular. There's really no reason to invest in the S&P500 anymore.
- danieltillett 11y ago
  That makes sense. I am surprised why anyone would want to choose S&P500 in this case.
  - Tomte 11y ago
    Because most of us don't live in the United States. Good luck finding a total market index fund elsewhere.
atinoda-kestrel 11y ago
> Are there any index funds that track the entire market? Wouldn’t investing in all companies solve the problem of index tracking? Yes, there are funds that try to match the entire market. Vanguard runs a couple "total market" indices (VT and VTI, for example), and there are more. But that's not to say that they actually invest in the entire market. They don't; they use sampling to try to match the performance of the thing they index. (Vanguard, at least, gets very very close to this...) Disclosure: I am invested in in VTI.

jackgavigan 11y ago

Matt Levine stands out amongst journalists and commentators as someone who actually knows what he's writing about because he's been there, done it, and now wears the t-shirt when he's changing the oil on his car.