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Managers tread lightly over index reconstitution

Firms attempt to balance cost with holding to the benchmark

Vanguard’s Mark Fitzgerald thinks managers have to take many factors into consideration.

When it comes to index reconstitutions, money managers running passive strategies are working hard to strike a balance between staying true to the benchmark and incurring increased costs for clients.

As Pensions & Investments went to press, money managers were continuing to grapple with the reconstitution of the FTSE Russell family of U.S. equity indexes, which took place at market close June 22.

Ivan Cajic, head of index research at agency-only brokerage firm Investment Technology Group Inc. in Toronto, said the FTSE Russell change is "historically the heaviest trading day of the year in the U.S."

According to FTSE Russell, $9 trillion in assets track the Russell U.S. indexes.

Forecasts by ITG put market-wide turnover associated with the reconstitution of the indexes, including the U.S. large-cap Russell 1000 index and the U.S. small-cap Russell 2000 index, in the $300 billion to $400 billion range. The group expects rebalance trading of $27 billion per side, up from $23 billion in 2017.

"The reconstitution of indices are probably the most important events in the index calendar, as the change in the index constituents and their respective weights can be significant," said Colm O'Brien, London-based head of index, Europe, Middle East and Africa at Legal & General Investment Management. "From an investment perspective, we place a lot of attention around these events and the trading strategies we employ to ensure that we transition our clients as efficiently as possible from the old to the new index."

Index reconstitutions happen on a set, and pre-announced, timetable. The FTSE Russell changes are annual, while MSCI Inc. and Standard & Poor's Corp. occur quarterly — typically in March, June, September and December. There are also a number of one-off index changes caused by corporate actions and other events that managers need to address throughout the year. On the fixed-income side, sources said rebalancings can occur monthly to take new bond issuance into account.

The providers also typically outline index changes a week, or even longer, ahead of the actual reconstitution.

"Usually in the days and weeks heading in(to a reconstitution) you're going to start seeing some increased volume, increased price volatility," said Mr. Cajic. And index managers are not the only causes of increased activity. "You have fundamental investors trading to take advantage of added liquidity, speculative alpha managers trying to pre-position in advance as something being added could (cause them to buy) in advance in the anticipation of added demand. There are various participants competing against each other in terms of price and liquidity."

On the week of the actual rebalance, Mr. Cajic said ITG sees a "ramp-up in volume and volatility. It depends on the size of the trade."

But even though index managers know when and what changes are coming — and reconstitutions are nothing new — the increased flow of assets into passive strategies plus a sharpened regulatory and client focus on fees and making every basis point count, is piling on pressure to get rebalancings right. A 2017 PricewaterhouseCoopers report forecast global assets invested in passive strategies to hit $36.6 trillion by 2025, from $14.2 trillion in 2016.

That means managers need to pay more attention to the decisions they make, where they have the flexibility, when trading around reconstitutions.

"We have always paid a high level of attention to index rebalances. … As more money started to track popular indices there is the potential for a supply-and-demand imbalance at the index implementation point, which could create an artificial price," added LGIM's Mr. O'Brien.

While most strategies track large liquid indexes, the size of positions held by some managers also needs to be carefully managed when deciding whether to trade on a reconstitution.

From the perspective of large asset managers, major concerns are "can we get our trades into the market in a cost-effective way that doesn't (create) market impact, how can we control risk around that trade and how do we keep our funds tracking the benchmark," said Mark Fitzgerald, head of ETF product management, Europe, at Vanguard Asset Management Ltd. in London.

Picking times

Where money managers have the flexibility to trade around index reconstitutions, choosing whether a rebalance is something they need to do against a client mandate, they use technology and tools to analyze potential changes.

Investors generally opt for index strategies for broad low-cost exposure to markets, looking for market returns, sources said.

That means it's more important than ever to consider the need to trade every change. "Quite often you don't," said Julian Harding, global head of core beta research at State Street Global Advisors in London. "It could be you reduce the turnover and reduce the cost. Then the other (consideration) is the cost incurred with trading. This risk-return-cost triangle is something people sometimes forget."

State Street looks at rebalancings and the turnover generated by changes, considering additions and deletions, size, sector, country and region.

"There are lots of dimensions," Mr. Harding said. "Then (there is) analysis of trading patterns associated with index changes across all rebalances — we look at supply/demand, the impact on pricing and the impact on turnover of securities around that index change point. Systematically that has been analyzed over many years."

The firm also takes input from its trading desks around the world and global portfolio management teams to come up with what Mr. Harding referred to as "global organized trading strategies — our best ideas around how we can trade a particular rebalance. … Here we are looking to preserve wealth for clients and give them the proper market exposure they're entitled to, rather than just trading the index and producing" market returns minus the fees associated with the trades. "It is a value-added approach to managing index funds … but we don't have an alpha target," added Mr. Harding.

State Street also draws on quant analysis around trading patterns, liquidity, turnover in markets and its dedicated trading cost analytics group. Prior to a trade, the group looks at the potential cost, and following a trade it considers the results.

Advance notice

Other index managers use pre-reconstitution information to help decide when and whether to trade. "When it comes to reconstituting an index, some providers provide information a few days in advance, sometimes weeks. The more notice the better, as that enables portfolio managers to look at holdings, work out which are the most liquid stocks, which trades we think we might have to trade flexibly — although the index change point will be a specific point in time, if you identify that maybe you have some securities that are not quite as liquid as others, you may decide to start trading those a bit early," said Vanguard's Mr. Fitzgerald. "Equally, you might trade a little bit afterwards — rather than push the price today, hold back and trade next week."

But for most securities that's not the case, he added. "As there is so much liquidity in the big, developed markets where most of the big assets sit, you are able to get your trade away with little problem. But (where a strategy) is not quite as slavish to the benchmarks, we spend time and energy analyzing the trade. Things have shifted where asset managers can use a range of tools to get their trades into the market that perhaps didn't exist a few years ago," he said.

Vanguard portfolio managers are also traders, added Mr. Fitzgerald, meaning they have direct market access and can trade themselves. "We don't have to hand over a trade list to a broker. We can work the trades ourselves, use (algorithms) to make sure trades are traded without showing our hand."

A manager may wish to sell 1,000 shares, and these managers may choose to only trade 10 or 100 at one point. "You work them into the market — it's quite sophisticated and there is a lot more to it than some people appreciate," said Mr. Fitzgerald. "I remember reading that computers ran passive funds — no, they don't. They are the tool that fund managers use to manage the portfolios, but they need (human) managers at some point to make discretionary decisions around the trading strategy. Technology has given (us) more flexibility and (made it) cheaper to execute."

"We have to balance the goal of not destroying value for our clients by trading at artificial prices against maintaining a tightly controlled risk environment for the portfolio," said LGIM's Mr. O'Brien. "With a sensible approach to index portfolio management there is a potential opportunity to trade at better prices than the index implementation point, and therefore produce a performance that is above that of the published index. However, we also have to be conscious of the costs associated with trading."

Sources added that an index does not factor custody fees and taxes into decision-making, something investors need to remember.