Where Bloomberg Discovers That Large Orders Have Market Impact

In my former life, my trading desk made a lot of money trading around index-related flows.   My bosses were amongst the first to grasp the impact of index fund demand and how it would affect the prices of the underlying stocks.   As a result, we were able to make such index-related trades a very profitable part of our business.   Over the years, of course, the “knowledge” made its way into the market, and the number of market participants willing to take these trading risks increased, which decreased the profitability and increased the risk of the business.

Today, the business is massively “marginalized,” (I mean, I was shocked to see that Charles Schwab is even marketing index-related trades to their retail clients!!! ) to the point where most of the impact is usually priced in very quickly – an effect you can observe by noting that frequently there is very little price impact at the actual benchmark time of the index change.

Which brings me to the article which prompted this post: Bloomberg’s Yuji Nakamura’s “The Hugely Profitable, Wholly Legal Way To Game the Stock Market.”

This post struck a nerve with me because it portrays index funds as the victim of nefarious market evildoers like “hedge funds” and “Wall Street trading desks.”  Reality is the opposite.  Let’s get into it.

The article begins:

“It’s an easy way to game the stock market, and getting easier by the day.”

Well, it’s the first sentence and the author already has it backwards.  The business of pre-trading index related flows used to be an easy business!  When few people knew about the flows or understood them, it was very easy for us to go out and buy the names that were going to be added to, say, the S&P 500 index.  We’d have relatively modest impact, since we weren’t competing with thousands of others trying to put on the same trade,  and we’d accumulate a position that we’d then sell back to the index fund at the time of the index inclusion.

Nowadays, however, this business is (and has been for roughly 10 years) hyper competitive, which is why you’ll see a stock gap up 5% or more as soon as the index change is announced:  a plethora of trading desks run out to compete to buy the stock to hope to capture more upside from the demand from index funds.   More on that in a minute – in the meantime, let’s continue with Nakamura’s article:

“With some deft maneuvers, 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.”

There it is: the insinuation that these evil Wall Street scummers are ripping off poor Mom & Pop!  ORDINARY AMERICANS!  The nerve of them!  Using “deft maneuvers”!  How evil sounding!

Nakamura points out that there is nothing illegal going on – but still chooses to use the term “front running”:

“The tactic, in some ways, resembles illegal front-running – – but in this case, it’s perfectly fine. The traders are simply buying stocks before they’re added to the indexes that, by definition, index funds must track.”

In fact, the tactic of trading publicly announced index changes in no way resembles illegal front-running, which is when a client gives an order to a broker who then goes out and buys the stock in his own account and sells it back to the client at a higher price.

“As the popularity of index investing soars to new heights, the emergence of index front-running is raising fundamental questions about so-called passive investment strategies, as well as how indexes are compiled and the role the funds themselves play in elevating costs. By one estimate, it gouges owners of funds tracking the Standard & Poor’s 500 Index to the tune of $4.3 billion a year, a sum that can double or even triple the cost of such investments.”

Here Nakamura uses the “tiny percentages of huge numbers yield huge sounding numbers” trick to make it sound like those Evil Wall Street D-bags are really ripping poor ordinary American mom & pop’s eyes out on these trades.  His own chart shows that even when you include estimates of these “hidden” market impact costs for index funds, the costs of index funds are a fraction of the costs for actively managed funds.

I think we have enough of a baseline to get to my point about the reality of how markets work.

Here’s the thing:  When you want to buy a stock, you have to buy it *from* someone.  Demand in excess of supply leads to rising prices.   Index changes create demand.  Our old rule of thumb was that when a stock was added to the S&P 500, index fund demand would account for roughly 10% of the stock’s float.   That’s significant demand!

So what happens when my trading desk buys the stock before the index inclusion?   Well, as you can imagine, I was interested in trying to buy low and sell high – so I’d use the time between the announcement and inclusion to try to position the stock as efficiently and effectively as possible.  I’d take the risk of price movement between my purchase and the index inclusion event.   There’s a key word in the prior sentence:  RISK: that’s what it’s all about.  The market is about transferring risk from those who don’t want it to those who do.  With risk comes the potential for profit – and loss!

Back in the beginning of my career, as I already noted, we thought this was a great business:  since we dominated the business, we had little risk: little competition and little slippage of knowledge of flows, which enabled us to better estimate impact and better manage our risk.   By the end of my career, however (as I also already noted), the business had become marginalized: it was very hard to estimate how many other trading desks out there had “prepositioned” the index changes and were thus going to “go the wrong way” on the index inclusion event “on the close” (market on close).

In this way, trading was very much like a game of poker: the next level thinking which moved beyond “what is my position” to “what is everyone else’s position.”  Of course, that’s almost always impossible to know, but if you look at the market impact of index related trades on market-on-close these days, you’ll see plenty of signs of “saturated” or “over-played” trades where the stock prices in question move the “wrong way” in the last several minutes of the day: the Market gets bigger than the trade.  In other words, the trade has become too competitive, and too much stock has been pre-positioned by trading desks trying to make this “easy money.”  So when they all sell into ordinary Mom & Pop’s index fund demand, prices tick down.

Now there are two questions:

1) do the index funds want to take the *risk* of price slippage?

2) if they don’t want to take that risk, are these pre-positioning trades I’m talking about helping the index funds? or hurting them?

Let’s start with question 1:  Sure: some index funds take SOME risk.  The more risk they take, the more stock they buy early, and the less stock they buy market-on-close on the index inclusion date.  As Nakamura’s article notes:

“Managers at Vanguard Group, which oversees $3 trillion, “mitigate a good portion” of the risk by gradually building positions over time in stocks that are scheduled to be added, said Doug Yones, the Valley Forge, Pennsylvania-based firm’s head of domestic equity indexing and ETF product management.”

Of course by doing this, Vanguard takes the *risk* that they might buy too much early, resulting in a net supply of stock on the close, and thus missing their benchmark, creating slippage for the fund, which may anger fund investors.  Vanguard, of course, is one of the Big Boys with one of the biggest index rebalance orders.  He Who Controls The Orders Can Best Manage the Risk – but that doesn’t mean that Vanguard pre-trading the index changes is riskless for them.  As I just noted above, they can’t control or even know what the rest of the market is doing, or how much “risk” the rest of the market is taking in pre-trades.

On to the utterly important question number 2:  are those indexers who don’t pre-trade helped or hurt by those Evil Wall Street D-bags who are using “deft maneuvers” to “front-run” Mom & Pop?

Let me put it this way: every share that I buy early – before the index inclusion date – and sell back to the index fund is one less share of “market impact” that these non-risk-taking index funds will have.  By way of example, let’s return to Nakamura’s article:

“Take American Airlines Group Inc., which joined the S&P 500 after markets closed on March 20. Because the addition of the carrier was announced four days earlier, nimble traders had plenty of time to get in front of the less fleet-footed. American jumped 11 percent over the span.

The cost was ultimately borne by index funds, which sparked an $8 billion buying frenzy in the two minutes right before the close — an amount equal to more than two weeks of the stock’s typical volume, data compiled by Bloomberg show.”

Well index funds probably didn’t buy $ 8B of AAL, but let’s just run with that number:  Nakamura notes that indexers bought more than 10 days worth of typical volume all at once on the close.   Thankfully, The Market knew about this demand and had already priced it in, by buying the stock over the previous 4 days and selling it back to the indexers – providing supply.

Here’s a thought experiment:.  Imagine if the S&P 500 didn’t publicly announce its index changes.  Imagine if, instead, they only sent a top-secret Snapchat message to official funds who had money indexed to their index, and not to Evil Wall Street D-bags who might use deft maneuvers to “front run” Mom & Pop.

In this thought experiment, would $ 8B of buy orders – 10 days worth of volume, per Nakamura’s assertion (I haven’t checked these numbers, by the way) – have more impact or less impact?

I suggest to you that The Market pre-positioning the stock over 4 days –  with the interest of profit (buying low, selling high – managing risk, managing execution quality)  – results in a more efficient accumulation of stock than trying to execute the entire index order market on close (stealthily: where The Market hasn’t prepared for the trade).

This gets us back to the title of the post:  orders have impact.  Larger orders have larger impact.   One cannot avoid that impact by trying to hide the fact that the trade exists.  Nakamura’s article cited a paper by Antii Petajisto which tried to evaluate the impact costs index funds face.  Petajisto reached a similar conclusion to the one I posited just above:

“Their study has also been featured in the financial press, where the authors have argued for example that “Russell needs to make their [index selection] process less transparent.”

We come to exactly the opposite conclusion: predictability in index composition is actually desirable for passive indexers. The price impact of index changes on the effective day of the change is generated by the coordinated demand due to index funds. The arbitrage activity consists of anticipating these changes days or even months earlier, buying the additions and then selling the entire position to index funds on the effective day. In effect, the arbitrageurs are thus helping to meet the large spike in demand by indexers by spreading the trade over a longer period of time. This is precisely why S&P started to preannounce index changes in 1989. Thus “silent indexes” where index changes are announced only after the indexers have traded would be more likely to hurt than help indexers. Instead, our recommended index-neutral strategies, where investors deviate from the crowd but act with full transparency, seem the most attractive alternatives to index investors.

Petajisto, later, goes on to make a point which I think is the same as my point here – and even jives with the title of my post.  In critiquing those who suggest that opaque index procedures and shorter index inclusion time leads would be better for indexers, he notes: “these conclusions arise entirely from the unsupported notion that it is the arbitrageurs and not the indexers who create the price impact.”   Rephrasing into my own words: price impact comes from the “inefficiency” created by the index demand.  Arbitrageurs price the impact of this inefficiency.   The more time they have to price this inefficiency, the better it is for the indexers.  Indexers cannot magically buy $ 8B of AAL at last sale market on close.   They’re better off when arbitrageurs take the risk and work that order over a number of days, then provide liquidity for the indexers.

Back to Nakamura:  his article seemed to suggest that AAL rose 11% in the days leading up to the index change because of some variety of legal front running.   My point, echoed by Petajisto is that AAL rose 11% because index funds had to buy a lot of it.  My claim (and Petajisto adds evidence to support this claim)  is that index funds would have had even more impact had The Market not had that 4 day advance warning of the index change.

In the end, after the headline grabbing, click-generating nonsense which led the article – that of the hedge funds using deft maneuvers to disadvantage ordinary retail investors – Nakamura takes the time to touch briefly on the other side of the story – aka: reality – which echoes many of the thoughts I’ve expressed above:

“For its part, S&P says it doesn’t dictate when index funds buy and its re-balancing process ensures everyone gets the same information at the same time.

“We don’t require them to trade in a certain way,” said David Blitzer, chairman of the index committee at S&P Dow Jones Indices. “That’s their business not ours.”

What’s more, arbitragers may provide liquidity for passive funds because they “assemble a lot of stock,” he said.

Anyway – Nakamura’s article touched a nerve with me because it was about an area of the market that was my core expertise, and it echoed a number of common misunderstandings about the price impact orders have in the market.   A key point that I’d hope novice readers take away from this post is that orders have impact: you can’t just trade a massive amount of stock at the price on the screen.   Orders have price impact.    Trying to pretend that no one else knows about your order doesn’t magically create liquidity on the other side of your trade, and evidence suggests (per Petajisto) that allowing The Market to effectively arbitrage supply and demand likely results in better execution for those with the big orders at hand.


Bloomberg: The Hugely Profitable Hugely Legal Way To Game The Stock Market

Petajisto: The Index Premia and its Hidden Cost for Index Funds


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