An advisor asked us to address the concern about the possibility of front-running a FTSE RAFI Fundamental Index. I passed the question directly to the research team at Research Affiliates and the following excerpt is the answer from Shane Shepherd, Ph.D - Senior Researcher with Research Affiliates LLC:

“The inclusion effect has been well documented in the S&P 500, both by academic researchers and industry observers. Front running can indeed be a problem for an extremely large indexer such as the S&P 500. However, in order to make front running profitable there needs to be two conditions in place: 1) we need to know which stocks to buy, and when to buy them; and 2) we need to have the index create enough market movements to deliver sufficient profits to cover our trading costs and risk budget.

Neither of these two conditions are present for the Fundamental Index strategies. With approximately 20 billion currently under management (divided amongst various indexes around the globe) there simply isn’t enough power in our trades to move prices any significant amount whatsoever. Secondly, our trades are not preannounced — neither the timing nor the names. While an astute trader may be able to recreate our strategy and predict future trades, the timing of our moves is unknown. Thus even if traders know the exact names that we may trade into — and even if we had the power to move prices — a front running strategy would require a great deal of fortuitous timing and market risk.

On another note, the academic literature has found that the S&P 500 inclusion effect results in a permanent, and not temporary, rise in stock prices. The short-term gain observed upon the announcement of inclusion in the index is not followed by a period of underperformance. There are conflicting theories as to why this might be — information signals, greater liquidity, shifts in downward-sloping demand curves, and increased investor awareness are all possibilities. The implication is that investors in S&P 500 funds would not necessarily be hurt by front running. Yes, fund managers may purchase at a higher price than they otherwise could; but since that price rise is permanent, they do not take any kind of future hit in terms of underperformance. The expected return to the fund is exactly the same as if they had quietly bought shares and never released the news of inclusion.

In summary, this is a problem that is certainly only hypothetical at this point, and unlikely to become an issue for a good many years.”

If you have any questions of your own, please feel free to send them to me at preetb@pro-financial.ca.