Even if you don't care about the index fund "front-running" "scandal", the section starting at "The value of market-making is hard to see and easy to criticize" is critically important to understanding why the markets work the way they do.<p>As always, Levine is fucking fantastic.
From what I can see, this article is on point, but is missing an important factor: the risk these "front runners" take. As soon as the announcement is made that a company is joining the index, it's public knowledge. In theory, the expected increase, minus a risk premium, should be priced in immediately. There will likely still be money to be made over the following days until the addition is complete, but it's far from guaranteed, and comes at the expense of reduced diversification. (Which I suppose is another way to say that you're getting paid for providing liquidity, as the article says.) Just because AA went up X% over the 4 days, or whatever, before it joined the index, doesn't mean the next stock will. Perhaps its jump will be overestimated by the HFTs, and retail investors trying to get in in the days following the announcement will end up losing money. Probably not, but it's certainly a significant possibility. So if a person wanted to pursue this active strategy, they would need to manage their risk appropriately. It's not necessarily a bad idea if you enjoy spending your time on that kind of thing, although personally I'd rather index (with a moderate small/value tilt).
Order-handling companies pay for "dumb"
flow. Vanguard can reduce their outright trading costs to negative by being as dumb about it as possible, and then use these negative costs to artificially lower their reported fees.<p>Just because Vanguard claims to be smart about it, doesn't mean necessarily they actually are incentivized to be smart about it or actually are in practice. People can still judge them by how close they track the index, but that is reported separately from fees, which are all a lot of current and future retirees look at after having fees fees fees drilled into their heads. And the indexes themselves take a hit, so you need to adjust for that with a much more complicated measure.<p>They can effectively launder bad (or even good) tracking of the index into lower reported fees, by letting the order handlers profit on the inanity (and kickback via order-flow payments), allowing the fund managers to give themselves higher compensation without commiserate alarming fees.<p>To what extent, if any, do they actually do this? Do they report their income from paid order-flow in the fund prospectuses? Do they break it out by the managed funds, vs retail flow from their clients? Do they get major concessions to their retail trading costs in tacit exchange for being dumb with their etfs?
This is called the "index rebalancing" trading strategy. Prop desks and hedge funds have known about it for decades. A lot of money is passively benchmarked to many popular indices provided by the likes of S&P, DJ, Nasdaq, etc... One reason people invest in funds that track these indices is because they believe the index provider is a good benchmark for whatever its tracking. For example, the S&P 500 tracks the 500 largest US names. The Nasdaq 100 tracks the 100 biggest (mostly tech-related) names that are Nasdaq-listed. etc... In addition to being a good benchmark, a set of rules (here are S&Ps: <a href="https://us.spindices.com/documents/methodologies/methodology-sp-us-indices.pdf" rel="nofollow">https://us.spindices.com/documents/methodologies/methodology...</a>) are published by the index provider that govern how stocks are added and removed to the index. Understanding these rules allows arbitrageurs (aka market-makers) to predict when names are moving before they are announced by the index provider. Since a fair amount of capital is already tracking these indices, the passive indexer will be required to buy/sell the names in the index in the right proportion so as to be properly benchmarked.<p>Another interesting point is that the Volcker Rule has more or less caused a massive shift of this type of strategy away from US investment banks and into hedge funds. I don't have real data on this - just my observations.
Matt Levine stands out amongst journalists and commentators as someone who actually knows what he's writing about because he's been there, done it, and now wears the t-shirt when he's changing the oil on his car.
Reference to hn thread discussing the original article <i>A Profitable and Legal Way to Game the Stock Market</i><p><a href="https://news.ycombinator.com/item?id=9844686" rel="nofollow">https://news.ycombinator.com/item?id=9844686</a>
More commentary from an ex-index arb trader:<p><a href="http://kiddynamitesworld.com/where-bloomberg-discovers-that-large-orders-have-market-impact/" rel="nofollow">http://kiddynamitesworld.com/where-bloomberg-discovers-that-...</a>
If it were 20+ basis points a year it should show up in the returns and as a failure to track the index. I am not an expert, but that isn't what I see eyeballing a chart of VFIAX over 35 years. It doesn't track perfectly by an amount that does matter, but not .20 basis points a year.<p>Also by this logic total market funds should outperform other indexes by a healthy amount over time. Also maybe not what we are seeing. Granted total market funds invest in something that is different from what other indexes track.