(Bloomberg) -- It’s an easy way to game the stock market, and getting easier by the day.
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.
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.
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 S&P 500 Index to the tune of $4.3 billion a year, a sum that can double or even triple the cost of such investments.
“Portfolio managers are aware of it, but some of them will say My clients demand an index fund, and I’m going to give it to them come hell or high water,’” said Michael Rawson, an analyst at Morningstar. “Yes, you matched the index return, but the investor is now worse off. You don’t hear about that as much.”
The predicament is growing by the day. Index equity mutual funds have grabbed market share in the U.S. every year since 2006. Assets in passive equity products have swelled to $3.7 trillion as low-fee investments became a favorite in retirement savings plans and a six-year bull market made it almost impossible for stock pickers to beat benchmarks.
It might be tempting to blame savvy Wall Street types for taking advantage of mom-and-pop investors, but one of the big reasons front-running exists is because providers of popular benchmarks such as the S&P 500 usually telegraph changes ahead of time. Another stems from the pressure that passive fund managers face to track those benchmarks as closely as possible, even if it means sacrificing potential returns.
Take American Airlines Group, 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% 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.
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, a quantitative hedge fund that analyzed data from 1990 to 2011. That’s equal to $4.3 billion in lost income in 2014.
A study in 2008 by Antti Petajisto, now a money manager at BlackRock, estimated the impact could boost the expense of owning an index fund by as much as 0.28 percentage points.
While that might not sound like a lot, the added cost would be almost three times the stated 0.11% management fee for the $213 billion Vanguard 500 Index Fund, the largest S&P 500 tracker fund of its kind. By comparison, actively managed stock funds charge an average 0.86% annually, data compiled by Investment Company Institute show.
“The moment you say index, you’re telling the world you’re going to be trading on this particular day,” said Eduardo Repetto, co-chief executive officer at Dimensional Fund Advisors, a fund firm that designs passive strategies that differ from traditional index funds by giving higher weightings to factors such as profitability. “If you have zero flexibility when you trade, it’s going to cost you money.”
Studies paint a similar picture of what happens to benchmarks around the world -- from Japan’s Nikkei 225 Stock Average to the FTSE 100 Index in the U.K. and MSCI’s global equity indexes -- when their members are reshuffled.
Bloomberg LP, the parent company of Bloomberg News, creates, licenses and administers indices for multiple asset classes that may compete with other index providers.
Some fund management firms are working to combat the problem. 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.
“It just comes down to being smart with your trades,” he said. “It’s a big enough deal that index managers are aware and spend time and energy making sure there isn’t an impact.”
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.
Dimensional’s Repetto says his Austin, Texas-based firm, which manages almost $400 billion, avoids buying stocks immediately before they go into an index. Instead, fund managers purchase them earlier or after the fact.
While the strategy increases “tracking error,” or industry-speak for how much index fund returns diverge from benchmarks, it can also help fund managers boost performance.
Dimensional’s $5.7 billion DFA U.S. Large Company Portfolio fund has done just that. Its annual return exceeded Vanguard’s comparable flagship S&P 500 index fund by 0.11 percentage points a year over the past decade, even as its tracking error has been seven times as great.
Petajisto and Morningstar’s Rawson also suggest passive funds that buy the entire market can minimize the damage of front-running. By owning almost every stock, there’s barely anything for arbitragers to buy first.
Vanguard’s $411 billion Total Stock Market Index Fund is the most prominent example. In the past decade, it has returned 8.2% a year, beating the firm’s own S&P 500 tracker fund by 0.4 percentage points, data compiled by Morningstar show.
That might not mean much now with U.S. equities well into its sixth year of gains, but the risk is that savers may be far less forgiving once the bull market falters.
“Because the performance has been good and the fees are low, they’re not noticing some of these potential flaws in indexing,” said Morningstar’s Rawson. “But it’s not something that should be ignored.”