The passive arbitrage cost is not material – Mark Northway

Critics have highlighted the erosion of value to index investors from frontrunning – but it’s an acceptable price to pay

The simplicity and predictability of passive investments is their attraction, but these features have now thrown up a $4bn annual controversy (and that’s just for US funds).

Investors who choose an index-tracking fund know which index it will track, and they know exactly how it will replicate its target index.

The problem is that if investors know, then everyone knows.

Indexes are reconstituted on a regular basis, and changes in an index mean that associated index funds and ETFs are forced to adjust their portfolios on a given day. Everyone knows the exact trades they will be making, the collective size of those trades, and the timing.

This is manna from heaven for active traders and arbitrageurs who can ‘front run’ index investors by buying or selling the securities that they know a passive fund will trade in the coming days or hours.

As a result, passive funds could be paying more for the stocks they buy and receiving less for the ones they sell.

But there is a subtlety, in that the effect of this front running is reflected in both the prices the passive fund achieved AND in the index itself – so it’s a hidden cost. It can’t be found in the fund factsheets, and it can’t be deduced from tracking error or tracking difference.

Fortunately, the cost of this value leakage has now been estimated by the University of Illinois1 and, as strong passive advocates, we’re rather pleased with the outcome.

This issue isn’t new to the industry; indeed, it’s something we regularly and openly discuss with clients. But it’s the first time we have seen a reliable estimate of its impact.

A necessary evil

The researcher estimates that US index tracking funds could be sacrificing $3.9bn a year in returns, equivalent to $29,000 for a saver who had built up a portfolio of $2m over 30 years. Perhaps a more realistic portfolio of $500,000 better fits the illustration – in which case the cumulative erosion would be just $7,250.

The scale of this cost is immaterial in the context of long-term savings, and is simply something that passive investors – and those advising on passive strategies – need to take into account as a component of the total cost of investing.

There aren’t really any win-win ways to get around this issue, and attempts to mitigate it tend to introduce complexity, cost, or both.


Alternative approaches

One provider that addresses the issue is Dimensional Fund Advisors. Dimensional follows a rule-based approach but doesn’t track a declared index and even allows its managers discretion over the timing of trades.

This approach means that Dimensional’ s future trades are not broadcast to the market, and therefore frontrunning them is virtually impossible.

As part of our work to unpack this issue, we ran parallel portfolios over a period of years using Dimensional funds and traditional ETFs and we compared the performance over time.

While the Dimensional portfolio did indeed outperform the ETF portfolio in our tests, this outperformance was partially offset by the difference in management fee. Both approaches produced very similar risk-adjusted results in our experiment.

Another alternative to foil the frontrunners might be to allow ETFs and index funds the discretion to trade on non-specified days, but again this is not a panacea.

By spreading the index rolls, a manager necessarily introduces tracking error relative to an index. Since tracking error is a key element in index fund selection, an action intended to benefit the investor would perversely decrease the attractiveness of the fund to that same investor.


Impossible aspirations

Frontrunning of index rolls is an inefficiency inherent to index investing, but it is a price worth paying.

Transparent, rule-based trading patterns give investors certainty, and they remove the temptation for human-based decision-making to influence allocations.

The University of Illinois research is again proof that index investing is simple in concept but complex in execution. This makes it imperfect but doesn’t detract from its value as a highly efficient means of harvesting market returns.

Mark Northway is Investment Director at Sparrows Capital.

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