Indexing is a complex, time-intensive process that requires a dedicated and collaborative investment team. A close look at a sample index reconstitution illustrates the complexities of managing an index strategy, and the criticality of collaboration and developing a trading strategy to achieve optimal outcomes for investors.
Often, investors think indexing is a simple, quasi-mechanical investment technique. Indexing, however, is a complex and time-consuming process that requires a strong team of investment professionals. Importantly, an index team collaborates to achieve the competing goals of effectively tracking the underlying index and minimizing wealth destruction caused by reconstitution trades and their associated market impacts. In this article, we focus on a reconstitution of a smart beta index to shed light on the complexities of managing an index strategy, as well as to underscore the importance of collaboration and developing a trading strategy to deliver the best outcomes for investors in their index investments.
Reconstitution Case Study
In this case study we showcase a recent reconstitution of a smart beta index that rebalances annually. Reconstitution, by way of background, involves the re-evaluation of a market index and the process involves sorting, adding, and removing securities to ensure that the index reflects up-to-date market style and capitalization. In this particular example, the smart beta index selects securities in the mid- and small-cap universe and follows an equal-weight approach to determine individual security weights. The total two-way turnover for this event was 120%.
Notably, index funds assume that 100% of a reconstitution takes place on a single day (the effective date), but most importantly, at one single point in time at the market-on-close (MOC) price. Explicit transaction costs, such as commissions or taxes, are not considered. Another key factor is that there is no consideration for the implicit cost associated with trades executed at the MOC. For example, if a security trades at $10 at 3:59 PM, yet due to MOC demand the security closes at $11, as long as the index investor bought it at $11, there will not be any tracking implications. However, in this example, the market impact of index activity led to a strong price movement effectively reducing the investor’s wealth by $1. For transactions in the United States and other developed markets, particularly in the large-cap space, these impacts represent fractions of basis points, but in less liquid markets the impacts can be very large.
In cases where we estimate that our size needs will be too large to trade all on the close, we will build a strategy that balances out market liquidity with benchmark risk. In some scenarios that means we will commence trading earlier in the day to provide intra-day market liquidity as well as closing liquidity. This tactic can be very productive, for nearly 30% of a day’s volume in small-cap trades in the last 30 minutes of the day.
When a new index reconstitution is approaching, the Portfolio Management (PM) team at State Street Global Advisors initiates what is called a “Pre-Trade Cost Analysis (TCA).” The PM team compares the existing portfolio holdings to the index holdings after the reconstitution to assess what the rebalance trade looks like. This analysis sheds light on many features, such as sector and country flows, as well as what the most illiquid securities are that will have to be traded.
The PM team works with our Transaction Cost Analysis team as it assesses the estimated market impact cost of trading 100% of the rebalance, given historical transaction cost data, such as bid-ask spread, expected market movement given asset size to be traded, commissions, and any other costs. With this information, the PM team is able to determine not only the overall cost of the rebalance, but also the granular details on each individual name. From there, the PM team is more effectively able to work on a trading strategy with the following two main objectives.
Minimize return dispersion between the portfolio and the benchmark
Minimize market impact and wealth destruction
Balancing these two objectives is often a challenging endeavor, and experience managing these types of strategies is deemed a key determinant to success.
Figure 1: Case Study Reconstitution
In this case study example, Figure 1 illustrates the Pre-Trade Cost Analysis. As Figure 1 shows, the total notional for this rebalance was $595.2 million. Given that this example is a reconstitution, the notional value of sells is similar to buys, leading to a cash neutral trade. Moreover, the weighted average daily volume for the entire trade was 32.6%. The average spread was 11.1 basis points (bps), while expected commissions were 4.2 bps. By far the largest estimated cost was what we call “impact cost” or expected price impact of our trades. This was estimated at 1.29%, resulting in a negative total impact of 1.33%. In other words, this report was telling the team that if we were to trade 100% of this rebalance on a single day, we would potentially face a 1.3% impact caused by our trading.
Figure 2: Case Study Top 5 Worst Names
Figure 2 shows the top 5 worst names from an expected total cost perspective. As shown, all of our demand and supply for these names exceeded 150% of the expected daily average volumes. This granular data allows the PM and trading teams to dissect the reconstitution and to craft a trading strategy.
Developing a Trading Strategy
Armed with the Pre-Trade Transaction Cost Analysis, the PM team engages our trading team to craft an implementation strategy. Trading 100% of this rebalance on the close of the effective date is not feasible. Therefore, we need to set a strategy that will enable the portfolio to remain fully invested at all times, will be able to buy and sell the required names in an orderly fashion, and at the same time, will minimize tracking error.
After careful consideration of the need to balance out the time for implementation, the liquidity situations that exist, and the exposures we are managing, we decide to focus on the most illiquid names and start pre-trading in a balanced, cash-neutral fashion a few days before the effective date.
Our trading activity is scheduled to take place over the next four days. The goal is to navigate across a myriad of execution avenues, including but not limited to, dealer advertisements, dark pool venues, and other electronic channels to source the maximum liquidity while also minimizing information leakage, and avoiding price impact while balancing cash. Broker selection is important especially in the small-cap arena as we want to have a dealer(s) that transacts in this space and can add value in finding larger-than normal-blocks in the process. Dark or “hidden” liquidity is nearly impossible to forecast, so patience is required as liquidity may show up for a moment, only to then evaporate. Part of the challenge is to balance opportunity cost with market impact; if we are able to find contra flows, then trading as a large portion of the volume is not a concern as long as we are not impacting the price (i.e. being price makers, not takers). With this in mind, we would start to trade in an orderly manner, while trying to maximize our chances at matching buyers and sellers with the least amount of friction as possible.
Lastly, our goal is to finalize this rebalance within a week. We believe we can optimize the market conditions around quarter end — a time when we expect a large asset allocation shift that will improve liquidity conditions.
Rebalance Week Trading
During the rebalance week, as set in our trading strategy, we pre-traded approximately $210 million or about 35% of the total notional rebalance amount. Over an entire week, traders and the PM team worked closely to not only ensure portfolio exposures were aligned, but also to maximize our chances of executing at the lowest possible cost.
Finally, on the effective date, we separated the remaining illiquid names from the liquid ones. The illiquid names were traded throughout the day. Our expectation of enhanced liquidity on month end turned out to be accurate. The remaining trades with low estimated impact cost, were deemed market-on-close (MOC) eligible, and therefore were traded towards the close of the trading session.
After a week of patience and hard work, we were able to complete this rebalance trade. The total execution value relative to the effective date’s close was a positive 0.63%, or approximately $925,000 in added value relative to the benchmark. Of course, this figure could have been negative or quite different. While the trades were buoyed by market dynamics outside of our control, this example highlights the importance of teamwork and dedication when managing index funds.
Figure 3: Case Study Trading Results
Although we highlight a small-cap smart beta strategy example, similar work and discipline go into each and every index rebalance. Unlike this example, most rebalances do not require this type of strategy, and estimated costs to implement for most regular rebalances are not this large. However, more often than not, there are individual names in client portfolios that do require this level of rigorous analysis and approach.
At State Street Global Advisors, we believe that wealth preservation and market impact minimization are equally important objectives to achieve as tightly tracking an index. Careful consideration for implementation should be paramount, and is particularly relevant in smart beta and/or mid- and small-cap spaces.
1Average half spread = Half of the weighted average bid-ask spread, expressed in basis points. Shown for informational purposes only, this cost is included as part of the impact cost estimate. 2Impact cost = Citigroup BECS Expected Impact Cost = Estimated Spread Cost + Estimated Temporary Impact + Estimated Permanent Impact based on completing the order over one full day unless otherwise noted.
Information Classification: General Access
State Street Global Advisors Worldwide Entities
Abu Dhabi: State Street Global Advisors Limited, ADGM Branch, Al Khatem Tower, Suite 42801, Level 28, ADGM Square, Al Maryah Island, P.O Box 76404, Abu Dhabi, United Arab Emirates. Regulated by the ADGM Financial Services Regulatory Authority. T: +971 2 245 9000. Australia: State Street Global Advisors, Australia, Limited (ABN 42 003 914 225) is the holder of an Australian Financial Services License (AFSL Number 238276). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia. T: +612 9240-7600. F: +612 9240-7611. Belgium: State Street Global Advisors Belgium, Chaussée de La Hulpe 185, 1170 Brussels, Belgium. T: +32 2 663 2036. State Street Global Advisors Belgium is a branch office of State Street Global Advisors Europe Limited, registered in Ireland with company number 49934, authorized and regulated by the Central Bank of Ireland, and whose registered office is at 78 Sir John Rogerson’s Quay, Dublin 2. Canada: State Street Global Advisors, Ltd., 1981 McGill College Avenue, Suite 500, Montreal, Qc, H3A 3A8, T: +514 282 2400 and 30 Adelaide Street East Suite 800, Toronto, Ontario M5C 3G6. T: +647 775 5900. France: State Street Global Advisors Europe Limited, France Branch (“State Street Global Advisors France”) is a branch of State Street Global Advisors Europe Limited, registered in Ireland with company number 49934, authorized and regulated by the Central Bank of Ireland, and whose registered office is at 78 Sir John Rogerson’s Quay, Dublin 2. State Street Global Advisors France is registered in France with company number RCS Nanterre 899 183 289, and its office is located at Coeur Défense — Tour A — La Défense 4, 33e étage, 100, Esplanade du Général de Gaulle, 92 931 Paris La Défense Cedex, France. T: +33 1 44 45 40 00. F: +33 1 44 45 41 92. Germany: State Street Global Advisors Europe Limited, Branch in Germany, Brienner Strasse 59, D-80333 Munich, Germany (“State Street Global Advisors Germany”). T: +49 (0)89 55878 400. State Street Global Advisors Germany is a branch of State Street Global Advisors Europe Limited, registered in Ireland with company number 49934, authorized and regulated by the Central Bank of Ireland, and whose registered office is at 78 Sir John Rogerson’s Quay, Dublin 2. Hong Kong: State Street Global Advisors Asia Limited, 68/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. T: +852 2103-0288. F: +852 2103-0200. Ireland: State Street Global Advisors Europe Limited is regulated by the Central Bank of Ireland. Registered office address 78 Sir John Rogerson’s Quay, Dublin 2. Registered Number: 49934. T: +353 (0)1 776 3000. F: +353 (0)1 776 3300. Italy: State Street Global Advisors Europe Limited, Italy Branch (“State Street Global Advisors Italy”) is a branch of State Street Global Advisors Europe Limited, registered in Ireland with company number 49934, authorized and regulated by the Central Bank of Ireland, and whose registered office is at 78 Sir John Rogerson’s Quay, Dublin 2. State Street Global Advisors Italy is registered in Italy with company number 11871450968 — REA: 2628603 and VAT number 11871450968, and its office is located at Via Ferrante Aporti, 10 - 20125 Milan, Italy. T: +39 02 32066 100. F: +39 02 32066 155. Japan: State Street Global Advisors (Japan) Co., Ltd., Toranomon Hills Mori Tower 25F 1-23-1 Toranomon, Minato-ku, Tokyo 105-6325 Japan. T: +81-3-4530-7380. Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #345), Membership: Japan Investment Advisers Association, The Investment Trust Association, Japan, Japan Securities Dealers’ Association. Netherlands: State Street Global Advisors Netherlands, Apollo Building 7th floor, Herikerbergweg 29, 1101 CN Amsterdam, Netherlands. T: +31 20 7181 000. State Street Global Advisors Netherlands is a branch office of State Street Global Advisors Europe Limited, registered in Ireland with company number 49934, authorized and regulated by the Central Bank of Ireland, and whose registered office is at 78 Sir John Rogerson’s Quay, Dublin 2. Singapore: State Street Global Advisors Singapore Limited, 168, Robinson Road, #33-01 Capital Tower, Singapore 068912 (Company Reg. No: 200002719D, regulated by the Monetary Authority of Singapore). T: +65 6826-7555. F: +65 6826-7501. Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Zurich. Registered with the Register of Commerce Zurich CHE-105.078.458. T: +41 (0)44 245 70 00. F: +41 (0)44 245 70 16. United Kingdom: State Street Global Advisors Limited. Authorized and regulated by the Financial Conduct Authority. Registered in England. Registered No. 2509928. VAT No. 5776591 81. Registered office: 20 Churchill Place, Canary Wharf, London, E14 5HJ. T: 020 3395 6000. F: 020 3395 6350. United States: State Street Global Advisors, 1 Iron Street, Boston, MA 02210-1641. T: +1 617 786 3000.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent.
The views expressed in this material are the views of Nat Evarts and Emiliano Rabinovich through April 29, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
All information is from State Street Global Advisors unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Past performance is not a guarantee of future results. Investing involves risk including the risk of loss of principal.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
For EMEA Distribution: The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.
This information is for informational purposes only, not to be construed as investment advice or a recommendation or offer to buy or sell any security. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. There are no guarantees regarding the achievement of investment objectives, target returns, portfolio construction, allocations or measurements such as alpha, tracking error, stock weightings and other information ratios. The views and strategies described may not be suitable for all investors. SSGA does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Investing entails risks and there can be no assurance that SSGA will achieve profits or avoid incurring losses.
Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.
Images of NYSE Group, Inc. are used with permission of NYSE Group, Inc. Neither NYSE Group, Inc. nor its affiliated companies sponsor, approve of or endorse the contents of this program. Neither NYSE Group, Inc. nor its affiliated companies recommend or make any representation as to possible benefits from any securities or investments.