Author Topic: What are the risks of broad index funds?  (Read 2749 times)

scottish

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What are the risks of broad index funds?
« on: September 16, 2016, 05:54:57 PM »
This is primarily a thought exercise.    What could go wrong with funds that track the S&P 500 index?

For example, suppose a hedge fund was able to gain control of Standard and Poor's.    Could it re-balance the index to it's advantage so that when all the S&P500 index funds had to re-balance the hedge fund would make a killing?   (Would this type of stock manipulation be legal?)

Are there other scenarios that could work to our detriment?    I've been trying to think of some for quite a while, but the only one I could come up with is some type of inappropriate rebalancing scheme.

TexasRunner

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Re: What are the risks of broad index funds?
« Reply #1 on: September 16, 2016, 06:06:56 PM »
S&P isn't exactly a golden child.  They (along with a few other rating agencies) were pretty heavily involved in the manipulation that went into the 2008 crash- so I don't see something like this being out of the realm of possibility.

My main question is if a re-balance of sorts did occur, how would they capture a high enough percentage of the market to be damaging to each index investor?  If they rebalanced within the S&P, wouldn't you just own the same number of S&P combined stock count?  How would you lose?  I guess you are saying they rebalance to push some companies out and bring other companies in, within a narrow timeframe that screws over the index investing firms?

Aren't different index investors buying and selling semi-regularly (like on weekly schedules) but on different schedules from one another?  How would they screw over everybody in that market at once?

scottish

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Re: What are the risks of broad index funds?
« Reply #2 on: September 16, 2016, 06:29:16 PM »
Supposing they decide to pick on 3M, for example.

First the black hats short sell 3M.   Then they remove 3M from the S&P500.    As all the index funds have to sell their 3M stock, the stock price declines and the short positions increase in value.

I suppose non-index investors could view this as a buying opportunity and purchase 3M once the price starts to dip.

MustacheAndaHalf

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Re: What are the risks of broad index funds?
« Reply #3 on: September 16, 2016, 07:08:28 PM »
So the events you describe are: a hedge fund knows it will drop 3M from the index, it buys short options on 3M (which drives the price down already - the market knows something is up), and then drops 3M from the index.  Now the price of 3M falls further based on the inside information the hedge fund knew all along.  Uh oh.

The hedge fund winds up with big fines for insider trading.  And because it's the S&P 500, and this would be shocking, they would have to go for jail time (I hope!).  The hedge fund just reversed the "pump and dump" scam by doing a "short and profit" run on the index.

The overall problem is that you can't do much without turnover.  Passive index funds do not expect high turnover, and if S&P 500 tried it they would switch their index.  Investors would also protest if a large company like 3M or Apple got dropped from the "largest companies by market cap".  Investors might be able to sue for fraud, but certainly nobody would trust an index after this came out in the press.

And just to make the problem harder, how would they game a Total Stock Market fund?  Anything you drop makes no sense - it has to hold the whole market.

scottish

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Re: What are the risks of broad index funds?
« Reply #4 on: September 16, 2016, 07:37:58 PM »
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And because it's the S&P 500, and this would be shocking, they would have to go for jail time

Pretty sure the sub-prime lenders responsible for the crash in '08 didn't get jail time.   But the civil litigation route might be a good deterrent. 

Wikipedia says that index funds lose somewhere around 0.5% annually to arbitrage during rebalancing.   I also remember bumping into a substantial tracking error on an ETF once - something about market makers not buying creation units quickly enough to keep up with demand.

Using (artificial) arbitrage opportunities seems like a natural way to try and beat the system.

But I'm really just trying to understand what could go wrong with index funds.    They've been around since the '70's.    Has nobody come up with a way to scam them in 45 years?   


TexasRunner

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Re: What are the risks of broad index funds?
« Reply #5 on: September 19, 2016, 08:19:48 AM »
But I'm really just trying to understand what could go wrong with index funds.    They've been around since the '70's.    Has nobody come up with a way to scam them in 45 years?   

I would *say* no simply because there are multiple rating agencies that all sell their own indexes, and some ratings agencies that don't sell indexes but still rate the market.  The hedge fund in question would have to "own" all agencies simultaneously to drop something out within an index sell-buy period (I think typically a week) to achieve the short.  Not to mention, if one agency dropped it but none of the others did, the entire market could probably guess what would come out of it.

Of course, this may be occurring right now (that .5% you mentioned) but it is too incrementally small for the market to consider a problem.  It has to be pocketed somewhere.  I just don't think it would ever be possible to take 1% or more from the entirety of indexed funds without someone hitting the brakes- be it the FSC or somebody else.

jjandjab

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Re: What are the risks of broad index funds?
« Reply #6 on: September 19, 2016, 08:47:29 AM »
I agree with the "no way" to scam them argument about index funds. Or at least not in a meaningful way. Based the the prior example, a hedge fund or rogue/activist investor could somehow scam a 3M and try to make money on that single stock, but it would barely budge the indexes as a whole.

Would be easier to scam a smaller or controversial company (Herbalife, etc...), but no way they could interact with enough companies to move the SP500 or TSM.

Perhaps the only way I could see to scam them would be technological in nature - i.e. hack the system to create a "flash crash" and buy/sell the ETFs, but even then I think the systems are so redundant, that may not be possible in the current day and age.

Lets be honest - the hedge fund/money manager types already have a great angle - the biggest scam of all. 2% of assets and 20% of profits. Make millions convincing people you had a great investment once, that you can do it again, while raking in crazy fees...

MustacheAndaHalf

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Re: What are the risks of broad index funds?
« Reply #7 on: September 19, 2016, 10:34:29 AM »
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And because it's the S&P 500, and this would be shocking, they would have to go for jail time
Pretty sure the sub-prime lenders responsible for the crash in '08 didn't get jail time.   But the civil litigation route might be a good deterrent.
Which is why I said "(I hope!)" originally, although you deleted that when quoting me.

Wikipedia says that index funds lose somewhere around 0.5% annually to arbitrage during rebalancing.   I also remember bumping into a substantial tracking error on an ETF once - something about market makers not buying creation units quickly enough to keep up with demand.

Using (artificial) arbitrage opportunities seems like a natural way to try and beat the system.

But I'm really just trying to understand what could go wrong with index funds.    They've been around since the '70's.    Has nobody come up with a way to scam them in 45 years?
I wonder if that wikipedia article is out of date?  There used to be more opportunity to "front run" index funds, where traders bought in first and waited.  Then stocks rose sharply in price as large index funds purchased the stocks, and the traders sold into it.  I've read that Larry Swedroe dislikes the Russell index for their construction methods, which have weaknesses - but even that was years ago, and has probably been addressed.

Long ago some traders would front run the S&P 500 by estimating the next few stocks and when they would be added.  Upcoming merger?  Buy the 501st largest stock, and wait for it to become the 500th largest stock after the merger.  But Vanguard has known about that for quite some time.  I believe the main reason Vanguard S&P 500 holds 505 stocks (not 500) is to prevent front running as the index changes.  So I don't think Vanguard has this problem with the S&P 500, but there could be other arbitrage.

So again, food for thought: how can a scammer do anything to a Total Stock Market fund?  Any attempt to drop a stock makes no sense.  The only way in is with an IPO, and the SEC watches those extremely carefully.  And even then, a new IPO is a tiny fraction of the stock market's assets, and so a tiny fraction of a Total Stock Market fund.  If a big concern of yours is losses to arbitrage, you could buy a Total Stock Market fund.

triangle

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Re: What are the risks of broad index funds?
« Reply #8 on: September 19, 2016, 02:00:53 PM »
I don't think any single person or institution(*) could game a security or enough securities in the board index like the S&P 500. Since the index is market cap weighted most of the price influence is at the top. And there is enough active managers and individual investors to counteract blatant manipulation.

(*) I would be worried if the Federal Reserve Bank (aka Fed) started participating in the stock market like what is happening in Japan. Where BOJ owns a significant percentage of the Nikkei, over 10% I believe.  http://www.investopedia.com/articles/markets/052516/how-bank-japan-now-owns-90-top-10-stocks-boj.asp

scottish

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Re: What are the risks of broad index funds?
« Reply #9 on: September 19, 2016, 03:06:18 PM »
I didn't know that about the Bank of Japan.   I was surprised to see the Nikkei was finally going up after all these years though.

To paraphrase the article, the BoJ is spending trillions of yen to purchase stocks on the Nikkei.   And these funds are coming from where?   They're increasing the money supply, so that suggests that the BoJ is printing money to buy stock.    That doesn't sound like a good idea.

If I understand everyone correctly, the US stock market in particular is too large and well regulated for a scam involving the major indices - at least a scam much beyond the current arbitrage costs.

TexasRunner

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Re: What are the risks of broad index funds?
« Reply #10 on: September 20, 2016, 11:51:39 AM »
Here's the other thing I found out today...  ETFs are traded in baskets, and only directly to and from broker-dealers (Goldman-Sachs, Merrill Lynch, etc) to the ETF distributor (IE S&P 500 is Standard & Poor's).  For someone to gimmick this, they would need to short all baskets from multiple broker-dealers overnight- because they only buy/sell at market close.  The fluctuations we see (read -> we ignore) throughout the day are only a result of the distributor's previous day's selection volatility in individual stocks acting as a collective.  The number of 'shares' of S&P 500 doesn't change throughout the day.

That being said, different broker-dealers have different levels of indexes (as in Vanguard using 505 stocks for the S&P 500 as reported earlier in the thread)- and probably multiple 'baskets' with different levels of index within.  To keep it fairly even, Fidelity might have 4 baskets with 505 S&P stocks, 4 baskets with 500 S&P stocks and 4 baskets with 495 S&P stocks. 

To pull off the gimmic scottish was originally describing, you would have to: (1) align all baskets simultaneously for your company (seems improbable if not impossible because of broker-trader to ETF distributor contract), (2) initiate short sell of the lowest one or two stocks just before close, (3) wait for market close/open numbers to come in and see how well you did based on your vested companies now-indexed stock.  The problem is you have no control over what other broker traders are doing with their baskets (assuming you even had full autonomous control over what your company was doing with its own) and the market would respond to your sudden sell of a large portion of stock and drop the short-sell right back out of the index (assuming it even made it there in the first place).  The % volume of the lowest stocks are tiny.  Probably .2% or so.  You don't make any money, you break your contract with the ETF distributor (who has a lot more to lose if indexes are seen as unstable) and you probably broke the law.  Not much to gain and a LOT to lose (on a personal level).

TexasRunner

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Re: What are the risks of broad index funds?
« Reply #11 on: September 20, 2016, 11:55:58 AM »
I think the biggest risks to indexing are (1) government 'takeover' (not terribly likely in our country but possible when sh*t hits the fan), (2) some other market segment grinding to a complete and lengthy halt (as in 2008), or (3) an explosion of one sector overtaking the index without having brick-and-mortar assets to sustain it in failure (as if Goldman Sachs or someone were 85% of the S&P 500 and all other stocks only made up 15%- you could see this happening over a long period of time and re-diversify accordingly if it were even possible).

Jammu

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Re: What are the risks of broad index funds?
« Reply #12 on: September 20, 2016, 12:44:03 PM »
Yes good point. In 1999 or thereabouts I received a letter from Vanguard regarding the Growth Index fund. From memory, the letter informed me that a few high flying growth stocks had overtaken the index and it was no longer diversified. That should have been a sign to rebalanced my assets.

Obviously that problem corrected itself.

Interestingly the growth index eventually resumed it's performance of around a point better than the SP over time. It looked like death in the early 2000s.


triangle

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Re: What are the risks of broad index funds?
« Reply #13 on: September 20, 2016, 04:43:55 PM »
Also the Center for Research in Security Prices (CRSP) equity indexes were purportedly design to protect against abritrage.

From https://www.bogleheads.org/wiki/CRSP_equity_indexes:
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The indexes are weighted according to free-float market capitalization and are recalculated quarterly. CRSP has randomized procedures as a means of reducing the risk of arbitrageurs successfully front-running a scheduled index reconstitution.

A number of Vanguard funds now use their indexes. In some cases they continue to offer similar funds that use different indexes. For example the Mid-Cap ETF (VO) using CRSP and the S&P Mid-Cap 400 ETF (IVOO).

scottish

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Re: What are the risks of broad index funds?
« Reply #14 on: September 21, 2016, 04:15:14 PM »
That sounds similar to the scenario I was trying to describe in my first post.   If CRSP thinks it needs to take steps to reduce arbitrage in a rebalancing scenario this suggests there *is* risk attached to it.   I wonder...

I found an old paper (ca 2002?) here:   www3.amherst.edu/~grwoglom/SP500submit_joi.doc.  (It's a Word document, so be careful if you're using MS office).     The results are summarized as:

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Most recently, however, the belief that companies added to the S&P 500 enjoy a permanent stock price increase has been challenged.  Malkiel and Radisich [2001] find that the price reversal is larger the longer the event window studied, and that just as the initial price increase has grown over time, so too has the price reversal.  They conclude that a company’s addition to the S&P 500 has no permanent effect on its stock price.  Their evidence would suggest then that only trading effects are important in explaining the pattern of price changes for S&P 500 additions.

A more recent study (ca 2011) here:  https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr484.pdf claims much the same:

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We show that there is no permanent S&P 500 index effect with respect to value or comovement, in the sense that firms with the pre-event performance similar to the event firms but not included in the S&P 500 index experience similar changes in value and comovement as the event firms.

This makes me think that the historical risk has been pretty small.  Maybe CRSP's measures are just precautionary.


TexasRunner

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Re: What are the risks of broad index funds?
« Reply #15 on: September 21, 2016, 04:40:11 PM »
This makes me think that the historical risk has been pretty small.  Maybe CRSP's measures are just precautionary.

I would agree.  Say.1% of the S&P 500.  As described above, it would take 5-10% of the market in assets to achieve, but would only pull in .1-.2% at the most.  As such, it doesn't make financial sense...

However...   .1% of the market is still what?  500mil?  It is worth if for there to be protections in place for 500 million (on CRSP's side) but not worth it (on the broker's side) to try the scam.  Everything purrs along nicely...  :)

NorCal

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Re: What are the risks of broad index funds?
« Reply #16 on: September 21, 2016, 10:49:33 PM »
The S&P 500 isn't some magic black box with a manager deciding which companies go in or out.  It is the 500 largest US stocks by market capitalization.  Stocks are weighted by capitalization, which is the simplest method of weighting and requires no re-balancing.

There are stocks that are added or removed at set intervals based on M&A, bankruptcy, etc.  However, these are usually the smallest stocks that move in, and have a negligible impact on total returns of a cap-weighted index.

There are hedge funds that arbitrage stock prices based on their likelihood of being added or removed from an index (triggering forced buying or selling from index funds), however I imagine the returns have largely been arbitraged out based on the general simplicity of the strategy.