Amid the current furore over LIBOR-fixing, it’s worth taking a step back and considering how foolproof the index benchmarks underlying our tracker funds really are.
I’ve written a couple of blogs in the past pointing out strong evidence of traders positioning themselves to exploit index funds, ETFs, and other tracker products: “smart money” taking away from us muppets, to put it bluntly.
In “Rolling Into Trouble” I focused on the apparent skewing of short-maturity oil futures prices in February 2009. The days concerned were those on which oil-tracking ETFs, managing billions of dollars of investor money, were selling out of expiring futures contracts and buying longer-dated ones.
Now the fact that the prices of expiring oil futures ended up getting depressed on the particular days when ETFs were rolling out of them may simply have been a reflection of supply and demand. It may also be pure coincidence that investment banks—Goldman Sachs, for example—reported particularly large profits from their commodity trading operations in early 2009. But I’ve also heard comments to the effect that commodity ETF investors were systematically “date raped” by other oil traders.
Here’s another example, also from 2009, of how the price of a small stock exiting the Russell 3000 index ended up getting hammered on the day on which it was removed from the benchmark.
But before we call in the regulators, were the traders involved in these transactions doing anything wrong?
It’s worth asking what we would do if given information that X billion dollars was going to be selling a particular share, bond or commodity future next Tuesday afternoon. There’s no question of insider trading—the way that USO, for example, would roll its oil futures positions was entirely clear to the whole market. You just had to read the index rulebook.
There’s nothing bad in principle, in other words, with traders seeking to position themselves on the opposite side from and take advantage of large, predictable money flows.
There are even funds that have been set up to take advantage of the way passive funds rebalance themselves. Aviva’s Index Opportunities fund was set up two years ago and markets itself openly as being able to exploit inefficiencies in the way index funds are managed. The fund has done poorly since launch, which in one way is a reassuring reminder that it’s not as easy as one might think to gain from benchmark changes.
But are retail investors—at whom ETFs are targeted—sufficiently aware of the potential vulnerabilities of the indices their funds follow? I don’t think so. While attending our 2010 US ETF conference I lost count of the number of questions I heard from fund advisors to the effect that “oil went up 80% last year, so why did my oil ETF only gain 7%?”
Ultimately, the only way an index can be made foolproof and non-manipulable is for its rules to be made non-transparent, or for a substantial element of randomness to be brought into the index management process: for example, we’ll roll our oil futures each month but we’re not going to tell the market on which days and at what time. But the disadvantages of such an approach are also clear—a major part of the appeal of index funds is that they are transparent and that the underlying indices are rules-based.
So, unfortunately, creating a benchmark for an index-tracking fund that’s totally immune to others’ attempts at price-rigging is harder than one might think.
There are, however, some things we as investors can do to protect ourselves. We can ask a series of due diligence questions in relation to any tracker product. For example:
- By whom is the index managed and calculated and is the index provider independent from the issuer of the financial product and from those trading in it?
- How does the index provider get paid?
- Could there be any financial incentive for the index provider to include/exclude particular constituents?
- How vulnerable is the index’s investment policy to exploitation at rebalancing dates?
- What’s the likely turnover level within the index and could anyone associated with the tracker product gain from high turnover?
- Does the index fund manager get involved in so-called “outperformance” trades and, if so, who gets the benefit of any profits?
- What pricing sources does the index firm use and are they independent?
- If the index tracks an asset class for which there are no exchange-based prices, how reliable are those prices?
- Does the index tracker you’re considering represent too large a part of the underlying market (is there a risk your fund is like the JP Morgan “whale”)?
If the answer to any of these questions raises concerns, it’s best to steer clear.