How To End Index Gaming

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 How To End Index Gaming

Photo Credit: Mike_fleming

There was an article at Bloomberg on gaming additions to and deletions from indexes, and at least two comments on it (one, two). You can read them at your convenience; in this short post I would like to point out two ways to stop the index gaming.

  1. Define your index to include all securities in the class (say, all US-based stocks with over $10 million in market cap), or
  2. Control your index so that additions and deletions are done at your leisure, and not in any predictable way.

The gaming problem occurs because index funds find that they have to buy or sell stocks when indexes change, and more flexible investors act more quickly, causing the index funds to transact at less favorable prices. You never want to be in the position of being forced to make a trade.

The first solution means using an index like the Wilshire 5000, which in principle covers almost all stocks that you would care about. Index additions would happen at things like IPOs and spinoffs, and deletions at things like takeovers — both of which are natural liquidity events.

Solution one would be relatively easy to manage, but not everyone wants to own a broad market fund. The second solution remedies the situation more generally, at a cost that index fund buyers would not exactly know what the index was in the short-run.

Solution two destroys comparability, but the funds would change the target percentages when they felt it was advantageous to do so whether it was:

  • Make the change immediately, like the flexible investors do, or
  • Phase it in over time.

And to do this, you might ask for reporting waivers from the SEC for up to x% of the total fund, whatever is currently in transition. The main idea is this: you aren’t forced to trade on anyone else’s schedule. The only thing leading you would be what is best for your investors, because if you don’t do well for them, they will leave you.

Now, that implies that if you were to say that your intent is to mimic the S&P 500 index, but with some flexibility, that would invite easy comparisons, such that you would be less free to deviate too far. But if you said your intent was more akin to the Russell 1000 or 3000, there would be more room to maneuver. That said, choosing an index is a marketing decision, and more people want the S&P 500 than the Wilshire 5000, much less the US Largecap Index.

So, maybe with solution two the gaming problem isn’t so easy to escape, or better, you can choose which problem you want. Perhaps the one bit of practical advice here then is to investors — choose a broad market index like the Wilshire 5000. At least your index fund won’t get so easily gamed, and given the small cap effect over time, you’ll probably do better than the S&P 500, even excluding the effects of index gaming.

There, a simple bit of advice. Till next time.

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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