Index Arbitrage Explained

Nowadays, taking exposure to an equity market is often synonymous with investing in an index. This is illustrated by the success of passive management and the thriving business of index funds, and more recently ETFs. Passive managers face increasing competition, however, as investors request higher performance and lower tracking error. To address this conundrum, managers are left with little leeway and must rely on as few deviations from the index guidelines as possible. By doing so they will engage in what we refer to as index arbitrage.

In this article we will describe how managers can deviate from the index to enhance a passive portfolio’s return while keeping the tracking error as low as possible.

The first possible deviation we will talk about arises from index rebalancings. The substantial assets managed under passive strategies generate massive investment flows when such rebalancings take place. This might translate into temporarily abnormal returns and suboptimal execution for funds tracking the index.

The second divergence occurs as a result of corporate actions, such as rights issues, dividend announcements and payments, and so on. The standard handling of such events by index providers may also be suboptimal.

It’s worth pointing out that techniques exist to enhance a passive portfolio’s performance while keeping the tracking error low. Stock lending optimisations are probably the most popular of those techniques. However, they won’t be addressed here as we regard these activities as part of the management of any equity fund and not specific to the management of index portfolios.

Index Reviews And Arbitrage

In order to remain representative of their market, indices usually integrate review mechanisms to adapt their universe over time. Reviews can be performed by dedicated committees (as in the case of the S&P 500) or defined by a set of rules that governs the addition and deletion of stocks in the universe. The former case usually allows an element of discretion, whereas the latter does not.

However, even when an index is run by committee, public guidelines usually exist so that decisions are somehow predictable. Most commonly, indices are rules-based and reviews occur periodically according to a known schedule. Additions and deletions are subject to a prior communication, detailing to market participants what stocks must be traded, in what proportions and the date on which the trades should be implemented (often referred to as the “effective date”). The fact that index changes are based on public information and do not incorporate predictions of future returns is of particular importance, as we will see1.

Arbitrage Mechanism
Since index fund managers are typically concerned with minimising tracking error, they have an incentive to trade on the effective date in order to keep their portfolio’s performance in line with that of the benchmark. This will create positive investment flows into stocks added to an index and negative flows from stocks deleted. According to the efficient market hypothesis, such flows, when deprived of any new non-public information, should not have any impact on prices. However, results can differ in practice.
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