How To End Index Gaming

 

 

Photo Credit: Mike_fleming

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.

1. Define your index to include all securities in the class (say, all US-based stocks with over $10 million in market cap), or
2. 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.