
Can You Really Game Index Funds? - zweiterlinde
http://www.bloombergview.com/articles/2015-07-07/can-you-really-game-index-funds-
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tptacek
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
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.

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tempestn
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).

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anonu
most of the juice is in predicting the move before the public announcement

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tempestn
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.

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cma
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?

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snowmaker
Is there any evidence that Vanguard gets kick-backs in return for their dumb
order flow?

I would think that would be a HUGE scandal if it were true and ever came out.

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cma
I haven't offered any, and it would most likely be illegal if it was
explicitly going on. And there is likely a wall between the different trading
desks (though often the physical embodiment portion of this is literally a
cubicle wall the employees can hear each other over). But the orderflow
compensation doesn't need to cross over into the retail desk if the ETF itself
has enough trading volume to mask some kickback without appearing too
egregious.

But price fixing is also illegal--nevertheless, two gas stations across the
street at a profitable intersection can engage in it solely through price
signal tit-for-tat[1]. This effectively masks intentionality.

Much more fantastical and speculative: machine learning algorithms at both
firms could now, or in the future, arrive at this cooperative strategy, even
with the only communication being through price signals. Without any human
ever even knowingly giving the explicit go-ahead.

[1]
[https://en.wikipedia.org/wiki/Prisoner's_dilemma#The_iterate...](https://en.wikipedia.org/wiki/Prisoner's_dilemma#The_iterated_prisoners.27_dilemma)

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anonu
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...](https://us.spindices.com/documents/methodologies/methodology-
sp-us-indices.pdf)) 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.

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jackgavigan
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.

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kqr2
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)

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kasey_junk
More commentary from an ex-index arb trader:

[http://kiddynamitesworld.com/where-bloomberg-discovers-
that-...](http://kiddynamitesworld.com/where-bloomberg-discovers-that-large-
orders-have-market-impact/)

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

~~~
KingMob
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.

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tptacek
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.

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evanpw
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.

~~~
tjradcliffe
Many years ago I did a comprehensive analysis of Canadian mutual fund returns
over about 20 years, and found that the average return per year was dead on
the market. The distribuiton of returns was Guassian and had a width of about
1%. I concluded from this that in fact fund managers can beat the market... by
precisely amount they pay themselves.

This is evidence for the "second order version of market efficiency" your
mention: it was uncanny, and put me into index funds for life (that, and the
fact that there was no way of predicting from year-to-year which funds would
beat the market the following year.)

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arielweisberg
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
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.

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URSpider94
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
The majority, sure, but not all. Look at since-inception charts of POGRX, VHT,
and BRK.B for example.

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Tideflat
However, for a lazy or casual investor discovering the difference between the
good managers and the lucky managers is very hard.

~~~
maaku
Eh, just compare the active fund against the S&P 500 on a suitably long enough
horizon:

[https://www.google.com/finance?q=NYSEARCA%3ASPY%2C+NYSEARCA%...](https://www.google.com/finance?q=NYSEARCA%3ASPY%2C+NYSEARCA%3AVHT%2C+NYSE%3ABRK.A%2C+MUTF%3APOGRX&ei=ejmdVZi2FYmsigKX-4LgBg)

I'll admit it's looking for a needle in haystack though. In all my looking
I've only found these three. Really just VHT and POGRX, since the success of
BRK (Warren Buffett's company) is common knowledge.

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

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p1mrx
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
That makes sense. I am surprised why anyone would want to choose S&P500 in
this case.

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Tomte
Because most of us don't live in the United States.

Good luck finding a total market index fund elsewhere.

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meeper16
How about a historical back-test? Should be simple enough.

