The hugely profitable, wholly legal way to game the stock market

(Bloomberg) — It’s an easy way to game the stock market, and getting easier by the day.

With some deft maneuvers, hedge funds and Wall Street trading desks are reaping hundreds of millions at the expense of index mutual funds, the investments of choice for a growing number of ordinary Americans.

The tactic, in some ways, resembles illegal front-running — but in this case, it’s perfectly fine. The traders are simply buying stocks before they’re added to the indexes that, by definition, index funds must track.

As the popularity of index investing soars to new heights, the emergence of index front-running is raising fundamental questions about so-called passive investment strategies, as well as how indexes are compiled and the role the funds themselves play in elevating costs. By one estimate, index front-running gouges owners of funds tracking the Standard & Poor’s 500 Index to the tune of $4.3 billion a year, a sum that can double or even triple the cost of such investments.

“Portfolio managers are aware of it, but some of them will say ‘My clients demand an index fund, and I’m going to give it to them come hell or high water,’” Michael Rawson, an analyst at Morningstar Inc., said from Chicago. “Yes, you matched the index return, but the investor is now worse off. You don’t hear about that as much.”

The predicament is growing by the day. Index equity mutual funds have grabbed market share in the U.S. every year since 2006. Assets in passive equity products have swelled to $3.7 trillion as low-fee investments became a favorite in retirement savings plans and a six-year bull market made it almost impossible for stock pickers to beat benchmarks.

Easy money

It might be tempting to blame savvy Wall Street types for taking advantage of mom-and-pop investors, but one of the big reasons front-running exists is because providers of popular benchmarks such as the S&P 500 usually telegraph changes ahead of time. Another stems from the pressure that passive fund managers face to track those benchmarks as closely as possible, even if it means sacrificing potential returns.

Take American Airlines Group Inc., which joined the S&P 500 after markets closed on March 20. Because the addition of the carrier was announced four days earlier, nimble traders had plenty of time to get in front of the less fleet-footed. American jumped 11 percent over the span.

The cost was ultimately borne by index funds, which sparked an $8 billion buying frenzy in the two minutes right before the close — an amount equal to more than two weeks of the stock’s typical volume, data compiled by Bloomberg show.

Hidden costs

Over a course of a year, front-running — of stocks going into and coming out of indexes — costs investors in S&P 500 tracker funds at least 0.2 percentage points, according to research published last year by Winton Capital Management Ltd., a quantitative hedge fund that analyzed data from 1990 to 2011. That’s equal to $4.3 billion in lost income in 2014.

A study in 2008 by Antti Petajisto, now a money manager at BlackRock Inc., estimated the impact could boost the expense of owning an index fund by as much as 0.28 percentage points.

While that might not sound like a lot, the added cost would be almost three times the stated 0.11 percent management fee for the $213 billion Vanguard 500 Index Fund, the largest S&P 500 tracker fund of its kind. By comparison, actively managed stock funds charge an average 0.86 percent annually, data compiled by Investment Company Institute show.

“The moment you say index, you’re telling the world you’re going to be trading on this particular day,” said Eduardo Repetto, co-chief executive officer at Dimensional Fund Advisors, a fund firm that designs passive strategies that differ from traditional index funds by giving higher weightings to factors such as profitability. “If you have zero flexibility when you trade, it’s going to cost you money.”

‘Being Smart’

Studies paint a similar picture of what happens to benchmarks around the world — from Japan’s Nikkei 225 Stock Average to the FTSE 100 Index in the U.K. and MSCI Inc.’s global equity indexes — when their members are reshuffled.