Front Running and Indexing

Winton Capital came up with some interesting research. In this case it's about using announced changes in index composition to buy or sell stock before the index fund (e.g. ETF) community does. Research is about providing facts about widely assumed effects. This is exactly what Winton Capital did. Looks like the effects of this type of "front running" comes down to an added hidden costs of 17 to 26 bps per year! That is a lot when looking at the TER of these funds.

Is it illegal? No! An example: The addition of American Airlines in the S&P500 was announced  four days in advance. Anybody trading AAL in that 4 day time span would be front running... As Matt Levine puts it:

" Four days! You didn't need to be a sophisticated low-latency computer algorithm to trade ahead of American's addition to the S&P 500 index. A regular human retail trader could have read the S&P news release on Monday afternoon, had dinner with friends, seen a movie, gotten a good night's sleep, spent Tuesday morning doing research to confirm that American was in fact going to join the S&P 500 and that a lot of index fund money tracks the S&P 500, gone out for a two-martini lunch, had 40 martinis, gotten blackout drunk, woken up in the hospital, spent 48 hours recovering and still had time to buy the stock before it joined the S&P on Friday afternoon. If it takes you more than four days to push a button, don't go around complaining that other people are too nimble and fleet-footed."

You can find the research here.

The Bloomberg article can be found here.

Matt Levine's view on the Bloomberg site are well worth the read. He defends the argument that index funds would not be able to buy the enormous amount of shares they need to if arbitrageurs would not engage in this type of "from running".