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 gaming.
- Define your index to include all securities in the class (say, all US-based stocks with over $10 million in market cap), or
- 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 gaming.
There, a simple bit of advice. Till next time.