Heightened volatility in the equity markets has led some money managers to seek excess return for their passive strategies through executing trades on individual index component shares away from the close of the trading day.
“The industry is moving this way. Skilled index managers are relying on adding a few basis points of value” to help boost passive equity returns, said Zed Francis, solutions portfolio manager at Legal & General Investment Management America, Chicago.
Trading away from the close — or away from the market open — helps portfolio managers squeeze those extra basis points from their passive equity strategies. They apply these trades in a strategy that gauges potential changes in equity indexes and trades in those securities — sometimes days and even weeks in advance. And they do it away from the open and close each day, because those have the highest trading volumes in any given trading session.
“It's a trading strategy,” said John Tucker, senior managing director, co-head of North American passive equity strategies at State Street Global Advisors, Boston. “The overall premise (that alpha in passive equities can be obtained trading off the close) is right, passive managers are looking at this, but it's not a trivial play at all.”
Fueling the move to these kinds of strategies is the shift to passive investing, particularly among asset owners like public pension funds, said Drew Miyawaki, head of global equity trading at LGIMA, Chicago.
“All of those investments are based on indexes that are rules-based, and the rules say that they're priced for valuation at the close,” Mr. Miyawaki said. “That one price point attracts a lot of different constituents all at the same time. They all focus on one price point — that's where you get the volatility.
“The close is not the problem; it's an opportunity,” Mr. Miyawaki said. “As large asset managers focus on benchmarks, we've done a lot of work focusing on why or why not focus on that price point. We now look for expectations around the close but trade away from the close in a risk-focused way.”
David Barron, senior portfolio manager at LGIMA, said the strategy focuses on individual securities in an index as opposed to the index itself. “Securities are added to the index at the close,” Mr. Barron said. “If I know the notional value of that security and what the impact of its inclusion (in the index) will be before the close, I can take advantage of that. What we're trying to do here is really trying to implement those index changes by trading away from the close in a risk-conscious way. We look at potential changes as far out as three months. We also look at primary and secondary public offerings. We look for the inflection point of a security instead of bunching all our trades with everyone else” at the close.
LGIMA had $62.6 billion in passive equity assets as of Dec. 31.
SSgA's Mr. Tucker said his firm also looks at passive management in terms of the individual security. “We replicate most indexes, but we look at every trade as an individual event,” Mr. Tucker said. “There are lots of indexes out there. You're trying to balance tracking error risk with opportunity costs and minimize the market impact. We have lots of systems and a sophisticated trading desk that helps us do this.”
Timothy R. Barron, Chicago-based chief investment officer at Segal Rogerscasey LLC, said he sees the rationale behind the strategy. (He is David Barron's father, but made clear that neither he nor Segal Rogerscasey is endorsing LGIMA's strategy.)
“Valuation at the close is more likely to be more expensive,” said Timothy Barron. “But for some, that's OK since the market is replicated with the close. If you're in lockstep with the index, and the index rules are that the valuation is struck at the close, then you're 100% in the benchmark. But if you trade a little differently, you'll have the opportunity to create a little value. And in a game where fees are in the single-digit basis points, if you can get a few basis points through trading away from the close, you could conceivably cover your fees.”
Equity index futures like CME Group LLC's Basis Trade at Index Close block trades, which allows for trade execution relative to the official close in advance, also have taken advantage of pre-close trades. “With BTIC, what we're seeing is the bid/ask spread tight throughout the day,” said Tim McCourt, CME's executive director of equity products in New York. As an example, when interviewed on April 13, Mr. McCourt said 1,700 contracts had been traded 3½ hours before the close that day. “Active as well as passive managers have already executed orders at midday,” Mr. McCourt said. “They no longer need to compile orders to trade at 3:30 (p.m.) or 4 p.m. Eastern time.”
Since BTIC's launch in November, Mr. McCourt said, there have been 300,000 total contracts representing $26 billion in notional value.
Mr. Tucker said that more passive managers are using similar trading strategies, making it more complex to do the trades.
“What's changed over the last few years is the amount of money now doing this,” Mr. Tucker said. “There are a lot more liquidity providers, so trading has gotten really complicated because so much money is now traded away from the close. And trading away from the close isn't always beneficial. Some managers are trying to predict changes in indexes, but that's easier to do with some but not with others.”
There are several variables that can affect such predictions, Mr. Tucker said. “The fact that indexes are rules-based makes that difficult,” he said “Trying to figure out others' liquidity needs is hard. Then there are shelf registrations (public offerings where issuers can offer and sell securities without separate prospectuses). Can they absorb that liquidity? And then there's the impact of (Federal Reserve) announcements. And then a lot depends on the index itself. Russell schedules broad changes in June; S&P has a committee that decides on composition. ... There are a lot of macro variables people have to look at.”
SSgA had $1.3 trillion in passive equity assets as of Dec. 31, mostly managed for institutional clients.
Not everyone sees the advantage of trading before the close in passive strategies. “I don't know if increased activity at the close is a detriment to the market,” said Sayena Mostowfi, principal, head of equities research, Tabb Group LLC, New York. “That also means there's more liquidity in the market. Aug. 24 (the day of the flash crash) had extreme volatility at the open, not as much focus on the close.”
What the strategy does exemplify is the growing importance of understanding market structure in portfolio management, Ms. Mostowfi said. “The tale of it is, the understanding of market microstructure is moving into the study of money management,” she said. “Portfolio managers have to be up to date on changes in market structure and their effects on things like the type of security traded, the type of exchange used, the time of day of the trade.” n