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.