Thursday, February 19, 2009

A trader's view of fundamental indexing

As fundamental indexing has gained a foothold in the consciousness of investors, there have been critiques of the theoretical underpinnings of the concept. Today, I would like to offer a trader’s view of fundamental indexing.


How fundamental indexing works
Here is how fundamental indexing works. Instead of weighting a portfolio by market capitalization, you weight it by some fundamental measure (e.g. sales, book value, etc.). In practice, fundamental indices are weighted by a combination of fundamental factors, rather than a single factor, in order to increase stability.

There is an important difference between cap weighted indices and fundamentally weighted indices. Cap weighted indices are far more passive. In the absence of membership changes and changes in shares outstanding because of buybacks or new issues, a cap weighted index portfolio requires no trading or portfolio rebalancing, other than the periodic re-investment of dividends.

By contrast, fundamental indices need to be periodically re-weighted and rebalanced. As stock prices move over time, the actual weight in a fundamentally weighted portfolio will deviate from the target fundamental weight. In practice, the rebalancing occurs annually.


The perils of rebalancing
Years ago, I was involved in the management of an international equity portfolio benchmarked to a GDP weighted EAFE index. The GDP weighting was conceptually appealing to investors at the time because Japan was such a large weight in the cap-weighted EAFE index. Virtually no manager was at cap weight in the EAFE portfolio because it would leave the portfolio with too much country specific risk. In practice, problems occurred on an annual basis when MSCI rebalanced the GDP-weighted EAFE index to its GDP weight. Japan’s weight in the index would typically move overnight by 5-10%. Such huge swings in the benchmark made it very difficult for an active, never mind passive, manager to run the portfolio.


An invitation for front-running
Any trader will tell you that the worst place to be as a trader is when the rest of the world knows what you have to do – and you have to do it despite that knowledge. This foreknowledge exacerbated the effects of the market crash of 1987 as market makers knew the portfolio insurers/program traders needed to sell more stocks as the market moved down. It also played a part in the sinking of Long Term Capital Management. The Street knew LTCM’s book. They knew the firm was in trouble. Arbs were front-running the firm’s positions, which worsened their losses.

As fundamental indexing gains in popularity, arbitrageurs, hedge funds and position traders can estimate the amount of rebalancing that will need to be done by the fundamental indexers – and front run them. This form of front running is not illegal, just smart trading, and it will serve to reduce the returns to fundamental indexing.

Investing in semi-passive investment strategies such as fundamental indexing is a game of inches. As fundamental indexing becomes more popular, rebalancing and implementation costs could easily take away any gains from the underlying investment concept.

4 comments:

Abe said...

This is all wrong - traders run the markets not the other way around!

keithpiccirillo said...

Dr. Hui,
The front running paragraph brought something I do not understand.
Assume that a mutual fund had a large short position in one or two stocks.
Could not the stock be driven up by hedge funds/and or a market marker and burn a mutual fund?
Obviously options would have to be taken out prior, to protect the position.
Can the holder of such a position be "sniffed out" via L2 or a algo program?
I read in Jim Cramer's book when he was a hedge fund manager his wife made him buy MORE securities in his short, to get traders to leave him alone, and the stock market actually bottomed later that day saving him from losing his hedge fund.
The thought came to me as investors seem to want Ken Heebner of CGMFX to develop more short positions.
They should probably be satisfied with what short risk exposure (3 or 4 basic materials such as MTL and BHP) he was willing to take last quarter.
I should get his new list of shorts, if any soon in the mail.
Thanks.

Petra said...

I agree with keithpiccirillo's posting. Cramer should have stayed with his wife! (lol) I guess for me it all boils down to understanding your short book to give you conviction. With Madoff it seems to be about proper due diligence these days more than anything else (particularly on shorts). Did you guys see the piece put out by Corgentum (http://www.corgentum.com) on due diligence in fund of hedge funds (http://www.corgentum.com/research-tenquestions.html ) I would love to see this adopted by more people.

Bernard said...

uniquely astounding posting on this subject - particularly intriguing considering the current hiccups us marketers are experiencing these days. I liked the Corgentum pieces as well.

I saw the recently put out a book on the subject matter in question, namely the diligence which is due to these managers of managers entitled, Hedge Fund Operational Due Diligence authored by a Scharfman, Jason. Probably worth a read in these turbulent crimson times...