River: Do you have thoughts about why the index effect differs among similar indices?
Rohit: One possible explanation for the disparity could be a correlation between value-add opportunity and turnover2. The average turnover for the S&P 500 between 2010 and 2018 was 45 basis points (0.45%), compared to 177 basis points (1.77%) for the Russell 1000 and 152 basis points (1.52%) for MSCI USA. Turnover is one of the key dimensions upon which the index effect depends. But we needed to continue our research around other possible drivers.
River: What dimensions of the index effect did you explore, and what did you discover?
Mitesh: It was clear from our early observations that we needed to study the index effect across a wide variety of dimensions. Our latest research highlights the differences in index-related value-add opportunity for index additions compared with index deletions. We also explored, at a security level, how liquidity (or illiquidity) impacts the index effect value-add opportunity.
River: Given that the index effect is changing (and even disappearing in certain instances), how did you expand the research to uncover new opportunities?
Mitesh: For several indices we modelled the index effect that would result if trading on expected index changes was possible closer to the cut-off period prior to the rebalance announcement. This shift substantially boosts the value-add opportunity, and the strategy turns out to be not as large a risk as it might otherwise appear; this is because reasonably effective prediction models can be built. Any increase in value-add opportunity might warrant consideration of this tactic by those seeking to capitalize on the index effect.
River: As a wrap-up, what would you say are the key takeaways we should remember from your research?
Jenn: First and foremost, index effect value-add opportunities continue to exist in specific indices across specific dimensions, but they do vary in magnitude and risk. Second, predicting index changes ahead of the rebalancing announcement date can potentially produce the greatest value-add. Our research reinforces the fact that, as the indexing space continues to change and expand, the nature of the index effect will continue to evolve. Last but not least, because every penny matters in today’s return-starved environment, we firmly believe that long-term institutional investors could benefit from index effect-related value-add opportunities (within conservative risk budgets) if implemented through a systematic approach based on rigorous and nuanced research.
For more information about this research, including historical context, detailed analysis and key take-aways, please download “The Past, Present, and Future of the Index Effect” from the Winter 2019 edition of The Journal of Index Investing.
Jennifer Bender is a senior managing director in global equity beta solutions at State Street Global Advisors; Rohit Nagori is a quantitative research analyst in global equity beta solutions at State Street Global Advisors; Mitesh Tank is a vice president in global equity beta solutions at State Street Global Advisors. River Wu is an equity portfolio specialist at State Street Global Advisors.