Know Your Enemy

Here’s an investing adversary that any index fund or ETF owner should be aware of. Passive funds create opportunities for others when their underlying indices are rebalanced, Jerome Nunan, client portfolio manager at Aviva, tells Paul Amery, editor of Jerome, you look after Aviva’s Index Opportunities fund. How does the fund work?

Nunan: The fund exists to take advantage of a market inefficiency that seems to be persistent. We aim to capitalise on the forced selling and buying activity amongst passive funds that occurs as a result of the regular rebalancing of equity indices.

Interestingly, although hedge funds and investment bank proprietary trading desks devoted a lot of capital between 2003 and 2007 to exploiting such anomalies, they still weren’t arbitraged away. We attribute this to the sheer weight of money that’s been going into passively managed funds, whether ETFs or other index-tracking strategies.

And now that a lot of those hedge funds and prop traders have quit the market, we actually feel that there are more opportunities than before, although markets have become more volatile as well. What is a typical trade for the fund?

Nunan: Usually we put on a position, whether long or short, either before the date of announcement of an index rebalancing, or on the announcement day itself. We then typically close the trade in the run-up to the effective rebalancing date.

We do our own modelling of which securities might join or be excluded from an index. As we run £13 billion of index funds ourselves, we’re aware of some of the market inefficiencies and we understand how index inclusions and exclusions are determined. Do stock prices move much between the announcement date of an index rebalancing and the effective rebalancing date? If so, isn’t this surprising? Shouldn’t prices adjust immediately after a rebalancing announcement is made?

Nunan: Yes, the largest opportunities to generate “alpha” occur between the announcement date and the effective rebalancing date. The reason for this is that if passive fund managers trade before the effective date they risk creating tracking error. So, even if it’s often better from a price perspective to buy the stocks that are being included in an index earlier rather than later, index fund managers have no incentive to do so. The same applies in reverse for deletions.

Usually, index fund managers end up making their trades in the stocks being added or deleted at the closing price on the last trading day before the effective date. In practice this means that by far the largest alpha opportunity for other investors occurs in the last 24-48 hours before the effective date, when the volatility is typically greatest. If index funds are throwing up such opportunities to make money for other investors, does that mean they are naturally inefficient or even a bad investment idea?

Nunan: I wouldn’t say that. People buy index-tracking funds for all sorts of reasons and the passive versus active debate has been going on for many years. Passive investment vehicles give people a certain exposure to the market and one that’s easy to understand. However, inherent in them is an inefficiency arising from the way passive funds are run, and specifically the focus that their managers have on minimising tracking error.


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