
A Profitable and Legal Way to Game the Stock Market - jack_axel
http://www.bloomberg.com/news/articles/2015-07-07/the-hugely-profitable-wholly-legal-way-to-game-the-stock-market
======
chollida1
I expected to see (1995) tagged to the end of this article.

I personally know 3 people who run their own money ( <5 million ) who do this
as their sole form of income.

Having said that, this isn't exactly easy. You need to know

1) if a stock is going into the index

2) when its going into the index

3) how much the index will buy

4) how much the index buy will affect the price of the stock

the first 3 are trivial for some index funds, though most have rules that
allow them some leeway here so there aren't always sure things.

The 4th is where you make your money.

And it isn't like there aren't other's doing this, the article makes it seem
much easier than it actually is.

If you play the game theory through you'd realize that if you knew the stock
is going into the index then you are probably too late to profit from it as
someone else will speculate the stock is going to go into the index the week
before and already move the stock.

Funds can't really avoid this, and to be honest they don't really care to
avoid it. It doesn't affect them at all, they are just supposed to mimic the
index. Though you do start to get into a strange feedback loop whereby the
index fund that is supposed to track the index starts to dictate how the index
moves, we'll call this the "index inception" effect:)

~~~
jerf
It's a nice, clear example of the anti-inductivity of the market:
[http://lesswrong.com/lw/yv/markets_are_antiinductive/](http://lesswrong.com/lw/yv/markets_are_antiinductive/)

The very act of noticing that something is a good strategy, and beginning to
trade on it, will over time drain away the utility of the strategy, until it
is useless or worse than useless.

Tracking indexes is "big", and has some brute simplicity about it, but
eventually the market will eliminate that as a viable investment mechanism.
(But that won't stop your metaphorical Dad from swearing up and down you need
to buy index funds....)

~~~
juliangregorian
Show me an actively managed portfolio that consistently beats an index fund
and I'll believe it. Until then, you guys can pretend to have all the inside
information you want, but numbers don't lie.

~~~
pa5tabear
Don't the top hedge funds consistently outperform the market?

~~~
the_gastropod
Yes, the top funds consistently outperform the market. No, the top funds are
not the same year-to-year. Predicting which funds will out-perform is the hard
(aka impossible) part.

------
aleyan
This is well known known effect. S&P rebalances it index through out the year
and there are always people trying to predict adds and drops and make some
money.

The real diseconomy happens in the Russel indexes. They are rebalanced
annually with the methodology for adds/drops announced ahead of time. Various
funds that are pegged to Russel are forced to rebalance at this time buying
and selling huge baskets in one day. To avoid large stock market movements and
capitalize on them traders try to predict the changes to the index and prebuy
the rebalance trade. Their actions through the market leading up to the
rebalance and agreements to sell the rebalance trade to the Russel pegged
funds reduce price swings on the day of the rebalance.

Trading desks that engage in the Russel trade spend the entire year preparing
for it, modeling the methodology, acquiring clients for the rebalance trade,
and prebuying the trade. Their profit comes from the difference between the
closing price (mostly governed by Russel adds/drops) on the day of the trade
and the price that they prebought at. Essentially their ability to accurately
predict the rebalance add/drops and acquire clients to sell the rebalance
trade to. There are desks that make $10s of millions this way on that day.
There may be desks that make $100 of millions this way.

PS. I may not have stated it clearly, but funds that are pegged to Russel
indexes make agreements with external traders to handle their rebalance trade
for them at a fixed bps to the closing price. Traders are able to make money
on this because they can take on risk and prebuy the trade; something that the
Russel indexed funds can not do.

~~~
joshu
Russell

------
briHass
Even in the worst case -- Vanguard doesn't lose anywhere near this premium --
we're talking 20-30 bps, or .25%. It's one of those scenarios where one has to
choose what is less bad. Sure, an active manager could play with the index a
bit more to help avoid this, but you'd be paying a lot more than .25% for his
effort.

It might, however, be a good enough reason to side-step this issue and use
Total Stock Market (VTSMX) instead of one based on an index that frequently
drops/adds stocks.

~~~
anonymousDan
But don't those Total Stock Market indices have some kind of weighting for
each stock? Wouldn't changes in the weightings just leave you with the same
problem? Or maybe I'm missing something?

~~~
briHass
They do, but Vanguard (and probably other fund companies) take a number of
steps to help prevent frontrunning. For one, Vanguard recently moved its
benchmark provider to FTSE Group (CRSP) for many funds, which takes more of an
averaged trade-price approach to determining weights. They also delay trades
and "packet" securities between indexes and buffering small changes in market
cap from predicting trades.

It's not impossible for someone to squeak some money out of the predictability
of an index, but it's not something that makes a ton of material difference
with a company like Vanguard.

Some info:
[http://www.bogleheads.org/wiki/Stock_market_indexing](http://www.bogleheads.org/wiki/Stock_market_indexing)

------
joosters
So, the writer of this article failed to give any proof other than citing the
case of one specific stock (American Airlines). Even then, it failed to give
any useful comparison (sure, the stock gained 11% in 4 days, but how did the
rest of the market do?)

It would take a bit of effort to grab the data for all stocks entering the S&P
for the last (say) 5 years, and then compare how these stocks did between the
announcement and the joining of the index, but this data is vital to making
the case that there is some market inefficiency here. Since the author doesn't
bother to do this work, how can they justify their conclusions?

They can't even manage to get the 'easy route' right (letting someone else do
the work). They cite 'one estimate' of a $4.3 billion cost but don't bother to
tell use who made that estimate, giving the readers no chance to check its
validity.

Lazy, lazy journalism IMO. At least quote your source, Bloomberg!

~~~
dsjoerg
The source for the $4.3B is given later in the article:

"Over a course of a year, front-running -- of stocks going into and coming out
of indexes -- costs investors in S&P 500 tracker funds at least 0.2 percentage
points, according to research published last year by Winton Capital Management
Ltd., a quantitative hedge fund that analyzed data from 1990 to 2011. That’s
equal to $4.3 billion in lost income in 2014."

That paragraph includes a link to
[https://www.wintoncapital.com/assets/Documents/WWP_HiddenCos...](https://www.wintoncapital.com/assets/Documents/WWP_HiddenCosts_final_revised.pdf?1405926282)

~~~
joosters
Oops, I completely missed that, I have no idea how :(

That paper is good, it answers all my questions that the original article left
unanswered. My dumb mistake for not reading it properly.

------
josh_fyi
Is there a "Index Frontrunning" fund which I can invest in? (The fund would
automatically frontrun all index changes, and so keep management fees to a
minimum.)

~~~
neals
I'd be more interested in a "Index Frontrunning Frontrunning" index, actually.

~~~
austin_y
No no no, you're behind the times. Index triple frontrunning is what's hot.

~~~
willis77
This is one of those Calc II problems where it turns out the profit limit as
the number of frontrunning funds -> ∞ equals something like e/log(2)

------
bill_from_tampa
I suspect this is more complex than just frontrunning. An article from the Fed
Reserve Bank of NY from 2011 discusses the whole process of being listed on an
index. Firms selected have been outperforming the market for several years at
least, and their metrics have been improving even before selection is
announced. This may be why these companies were chosen to replace others that
are failing.

The Fed report found that there is no long term impact of being chosen to be
on an index.

[http://www.newyorkfed.org/research/staff_reports/sr484.pdf](http://www.newyorkfed.org/research/staff_reports/sr484.pdf)

------
arielweisberg
Sure some people get rich, but for buy and hold investors it's mostly a non-
issue. The expense ratio of an S&P 500 index is still very small. A total
market fund won't have the same front running issues and the expense ratios on
those can actually be higher than the S&P 500 index funds.

IOW the overhead here is in the noise IMO.

~~~
gohrt
The point of the article is that owning an index fund is NOT buy-and-hold --
the indexs sell to rebalance, and do so in poorly timed ways (that is, in hige
fixed batches, contrary to standard advise to "drip"), exposing investors to
trading waste that the indexes are designed to avoid -- undermining the
purpose of the index fund.

0.2% waste is huge compared to the overhead fee of an index fund. VTSMX fee is
0.17%.

> higher than

You mean "lower than"

~~~
arielweisberg
I did mean higher than, but that is because I incorrectly included the
overhead of front running in the expense ratio when I think it would actually
manifest as a failure to track the index. Some total market funds end up being
a hair pricier (VTSAX and VFIAX are both .05% right now).

Still, if you look at VFIAX it tracks the index perfectly despite front
running so it is still nothing to worry about. The amount of money in index
funds is large so there is room for a few people to make some money without a
big impact. There is some deviation that is significant around the 35 year
mark, but do we even know that front running is the cause?

My understanding is that in practical terms weighting shouldn't matter for
indexes for the most part since you should only have to buy/sell when funds
enter/leave the index (that is the bug). The weight should track without any
active trading because it's based on market cap. You buy it and if the market
cap increases so does the holding and if it decreases so does the holding. No
need for trading.

Now if you want equal weighting among the 500. Well that is an issue. It's one
reason not to buy an equal weighted fund.

I know people are thinking of other more problematic indexes than the S&P 500.
I don't because I don't buy them so I haven't given a lot of thought to what
front running means to them. My investment objective is to hold the entire
investable space weighted by market cap (modulo currency risk and home bias)
and most indexes play no part of that.

~~~
breischl
>>I think it would actually manifest as a failure to track the index

No, because the stock was added to the index on the same day. So the fund is
tracking the index, and the index is doing what it said it would do. It's just
that they're both buying in an inefficient way that costs more than it might,
and others capitalize on that inefficiency.

------
jayvanguard
Sounds like it was written by someone with an interest in encouraging people
to buy expensive managed funds.

~~~
nerfhammer
You do see PR from Dimensional from time to time. Their slightly smarter index
funds probably do beat traditional index funds slightly but probably not after
their additional fees.

------
jgalt212
This is basically the primary trading strategy employed in the _The Ugly
Americans_. The time period covered is mid 1990's

[https://en.wikipedia.org/wiki/Ugly_Americans:_The_True_Story...](https://en.wikipedia.org/wiki/Ugly_Americans:_The_True_Story_of_the_Ivy_League_Cowboys_Who_Raided_the_Asian_Markets_for_Millions)

~~~
minimax
Was _The Ugly Americans_ good? I really enjoyed _Bringing Down the House_.

~~~
jgalt212
If you enjoyed _Bringing Down the House_ , I'd say you'd pretty close to
equally enjoy _The Ugly Americans_.

------
mangeletti
How is this considered unethical? If you know X will buy loads of shares of an
equity and you learned that fact legally through (presumably) public channels,
are you A) a scoundrel, or B) smart, for buying shares before X buys those
shares?

When somebody does something out of the ordinary it's necessarily considered a
"game" (read "scam") by the majority establishment.

The reality is that the index is buying the stock because it views it as a
good value, meaning that it is currently "under-priced". The index could be
then viewed as unethical for "stealing" the shares away from current holders
at a lower price than their intrinsic value, unless they were to tell somebody
first... like a "frontrunner". In most cases, the largest entity is viewed as
corrupt and evil, because it has the means to make the most efficient
decisions and capture all the value, but somehow indexes are regarded as
altruistic cooperatives.

They're not. S&P is owned by McGraw Hill Financial ($5 billion revenue), CME
Group ($3 billion revenue), and News Corp ($33 billion revenue).

~~~
icebraining
It's a 1%/99% story. The second paragraph pretty much says so: _" hedge funds
and Wall Street trading desks are reaping hundreds of millions at the expense
of index mutual funds, the investments of choice for a growing number of
ordinary Americans."_

Wall Street vs The Ordinary American™ makes for popular news stories.

~~~
mangeletti
Good point.

------
evanpw
Here is a different perspective from Matt Levine:
[http://www.bloombergview.com/articles/2015-07-07/can-you-
rea...](http://www.bloombergview.com/articles/2015-07-07/can-you-really-game-
index-funds-)

------
lingben
Just reading the title, I thought this would be another article about the
Congressional loophole - where members of Congress can trade on insider
information with impunity.

[https://firstlook.org/theintercept/2015/05/07/congress-
argue...](https://firstlook.org/theintercept/2015/05/07/congress-argues-cant-
investigated-insider-trading/)

~~~
gnopgnip
When does insider information become public? When does trading on it become
manipulating the market?

~~~
nkassis
I asked my compliance officer where I work that question, the answer was the
usual "It depends".

------
spectrum1234
The reason this happens is because of strict ruling on how index funds must
track the index (as the article mentions). There is no way around this
unless...

You loosen the requirements on how strict the index fund must track. Portfolio
managers are incentived to trade smartly if they are ALLOWED to. This is why
bulk trades are usually "random" to avoid front-running.

So a solution here is create a competitor to Vanguard who has loose, yet well
defined rules that define an index fund and how closely it must track an
index. That's it.

EDIT: Others are commenting on index funds have to redefine themselves and
add/subtract funds. But that is only the index, not the cause of the price
movements. That is looking at it backwards. You need to look towards those
moving the prices, like Vanguard, to find a solution.

------
littletimmy
Far as I understand it, the investment market exists on the edge between
actively managed and passively managed funds.

Actively managed funds exploit inefficiencies in the market, but the more
active funds there are, the less their returns through competition. Passive
funds are wonderful when the market is efficient, but the more passive funds
there are, the more inefficient the market, and the more profit active funds
can make. This should create a natural equilibrium between active funds and
passive funds where the market should "settle" and returns are optimal for
both parties.

Anyone know how to calculate that?

------
gesman
Mom-and-pop investors cannot take advantage of this (and many other
opportunities) because they have to feed a long chain of middlemen through
prohibitively high costs of trading as well as always being on the worst side
of bid-ask spreads.

And then of course the value and the cost of high quality information
delivered to you in a timely manner is a bit different than staring on CNBC
screens.

~~~
gaadd33
Why can't mom-and-pop investors open an account at a place like Interactive
Brokers and trade options on these events? The cost is pretty small per trade
(maybe $1-2 for most stock and option trades) and the bid/ask spread isn't
_that_ bad if you are talking about an 11% move in a very liquid stock.

~~~
gesman
Just because if market does not move fast enough in the direction of their
option trade - the value of their option investment will very quickly becomes
... $0.00

:)

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tosseraccount
The article really needs some hard numbers, not some "whitepaper estimates".

It's 500 stocks. How many randomly selected stocks do you need to almost equal
the performance?

Buying a new entrant on the day it debuts is not required to come very close
to matching the index performance.

The article points out that Vanguard “mitigates a good portion” of the risk by
gradually building positions over time in stocks.

Problem solved.

------
dotnetchris
When i used to very actively trade stock (even just thousands of dollars) i
used to monitor releases from companies like MSFT's and Buffet's holding
companies announcing upcoming stock purchases. I would then immediately buy
the stock before they can. Then i would sell it a few days or few weeks after
their purchase to lock in my 10-35% gain.

------
cyphunk
The issue of coerced hackers is an actual thing. They have been coerced by
Gov, Mafia but also large corporations. But this article...

> _One day, Okul said he wanted to obtain a pwnie for a client_

oh kay?

> _Building pwnies isn’t itself a crime; anyone can buy a version on the
> Internet._

hmm... that is false.

------
outside1234
A way to avoid this is to not buy the indexes themselves but deeper
capitalization based funds like VTI etc. This is still basically an index fund
but since it buys past the "500" it avoids this BS.

~~~
icebraining
Why would you want to avoid it? Either VTI is a better investment (for your
profile, of course) than the S&P 500 and such or it isn't; it doesn't really
matter if it's because of "index frontrunning" or any other factor.

------
phkahler
Can't the fund "managers" just add is some slop in their buying so they don't
cause such a large spike? The spike in demand is what makes this strategy
possible, so spreading the demand over period of days or even a week should
reduce the spike and the profitability of the strategy. I know they want their
fund to match the index, but if this ever became a problem I think they could
squash it pretty simply.

~~~
cpncrunch
According to the article, Vanguard already does this. I suspect it's mostly a
non-issue for properly managed index funds.

------
DannoHung
Is there a semi-passive fund that just responds to the announcements that
something is going into or out of an index?

Presumably they'd leave a little money on the table because they'd have to
guess how much to buy in or sell out, but it'd probably mitigate a good chunk
of the loss, right?

------
saneshark
It's much easier to do this with Commodity ETFs and Futures.

Doing it with equities or baskets of equities gets very complicated and if you
read the prospective of most ETFs pretty much all of them track the indexes
within some margin of error.

Commodity ETFs on the other hand have an underlying asset that will expire or
require taking delivery. Most of these ETFs are managed by a group of less
than 10 people. They simply do not have the resources to take delivery of an
underlying asset. They don't deal with the hassle of storing / taking delivery
unless things are really out of whack. Therefore, as a the underlying futures
contracts approach maturity, they need to rebalance their portfolio, almost
daily, and at minimum once every couple months. In a contango market, it is
very easy to front run these funds compared to ETFs that track equity indexes.

I should know, this was my primary trade 4 years ago before quantitative
easing killed all volatility in the market.

That being said, the Russell 2000 index is rebalanced only once per year.
Opportunities to front run that index with the futures contracts are one of
those trades that I miss dearly.

