Index Rebalance Trades
As assets held in funds that track broad equity market indexes in the U.S. exceeded assets held in actively managed funds for the first time ever at August 31, I thought it would be worth revisiting the impact of index rebalance trades on stock prices.
As stocks move in and out of indexes, buying and selling activity by index tracking funds can impact stock prices. One of the largest stock trading volume days in the U.S. occurs in late June as the FTSE Russell indexes are rebalanced. Newly listed companies like Uber and Lyft are added to indexes at the next reconstitution date. If a stock is moving into an index, the index tracker fund will need to add this stock to the portfolio in order to continue to track the performance of the index. Conversely, as stocks are removed from an index, the fund manager will need to sell the position. Fund managers are often measured by how closely they track the performance of the index so this is an important consideration as they attempt to minimize tracking error.
Hedge fund traders and equity market making desks at investment banks will attempt to take advantage of the temporary price distortion created by the additional demand or supply of stocks being added to or dropping out of the index. Market making desks hold inventory of stocks to meet the demand of investors. Under the Volcker Rule, these desks are required to hold only enough inventory to meet the “Reasonably Expected Near Term Demand” of investors. This rule was implemented to prevent the market making desks from taking excessive proprietary risk in an attempt to increase profits. Index reconstitution obviously impacts the demand for stocks from investors. Hedge funds are not subject to this rule so have freedom to construct the portfolio any way they like but they are always focused on profitability.
Quants at hedge funds and on market making desks attempt to identify stocks that will be added to or dropping out of indexes for several weeks before the actual index reconstitution and trade these stocks in anticipation of additional demand and supply. Critics of these strategies claim that these trades distort stock prices prior to the reconstitution and that this increases costs for investors. Proponents of the strategy maintain that the activity results in less price impact on the stocks as the trades are executed over a longer period of time so do not significantly change the daily volume. Because index tracker funds attempt to mimic the performance of the index as closely as possible they want to trade as close to the reconstitution as possible. If all index tracker funds traded at the same time, this would have a greater impact on stock prices because of excessive demand and supply over a shorter period. Index rebalance traders provide liquidity to index trackers as they execute their reconstitution trade.
Quants attempt to execute a relatively small % (say 5%) of the overall reconstitution trade but that requires an accurate computation of the asset flows into and out of index funds and an estimate of the activity of other players in the index rebalance trade. Historically, the performance of the Russell 2000 rebalance trade has been inconsistent from year to year, as a profitable trade one year attracted additional participants the following year and the trade became over-crowded and under-performed. For this reason, the trade is now performed by a handful of market participants who consistently provide liquidity from year to year.
The reality is that the US equity markets are highly efficient and the impact on investors from index rebalance trades doesn’t appear to be significant, even if there is a small probability that it could increase the cost. Tracker funds have become highly proficient at mimicking the index performance at all times, including during a reconstitution. Inclusion of a stock in an index has a more permanent impact on stock valuation so the impact of the index rebalance traders is likely to be more gradual moves than it would be if all the index trackers traded on the same day.