Lifting the lid on the trading behind index rebalances

Index rebalances can have a significant impact on your trading and ownership, but ETF owners are working behind the scenes to prevent their trades from moving the market, explained speakers at the IR Magazine Forum – Canada 2021. 

In a session titled ‘ETFs and the evolution of passive investment’, experts lifted the lid on how different investors approach index changes and discussed ways IR teams can prepare for these events. 

‘It’s really good to know what the thresholds are for some of these indices, to know whether you’re going to be up for either potential inclusion or exclusion. Because that’s going to have a material impact on your share price, and more so on your shareholder composition,’ said Billy Eckert, head of surveillance and intelligence at Q4.

‘If you are a company getting added to the S&P 500, you would expect hedge funds and algorithmic traders to buy aggressively over the next couple of days, knowing there is going to be that necessary demand from the index investors upon inclusion. So it’s an artificial price pop that you would see leading into the inclusion.

‘Then you’ll see a massive liquidity event on the inclusion itself, where there will be large block trades either after hours or [during] pre-market trading.’

While hedge funds buy and sell around index changes in search of alpha, ETF providers face a different challenge. They need to track the changes in the underlying index while avoiding moving the market through their own, sometimes very sizable, trades. 

‘Most ETF trades are placed at the close because… we have determined that our trade is not going to move the value of the security,’ said Anna Paglia, managing director and global head of ETFs & indexed strategies at Invesco.

‘But for the largest trades, we don’t know when we are going to trade. We may trade a few days ahead of the rebalance... we know the tracking error is explainable, but the biggest thing is not to move the market when you get to the rebalance date. 

‘People should not assume this is a... rules-based, predictable system where somebody pushes a button without regard for what happens in the marketplace. There is a science behind it. We have a number of people who work to make sure all of this is invisible to the extent that’s possible.’

The good news for IR teams is that it tends to be very easy to access information about indexes and ETFs, said Paglia. ‘If you go on the website of index providers, you will find the rule books,’ she said. ‘You will see these rule books can go from very generic to incredibly complex with formulas, algos and the like. There is full transparency there.’

The IR Magazine Forum – Canada 2021 also featured sessions on future IR strategies, crisis communications, the changing nature of brokers and ESG. Click here to find out more about the forum.