In the classic movie Wall Street, Michael Douglas’ character Gordon Gekko uses insider information to make money trading stocks. Insider trading is technically illegal and can run investors afoul with the SEC. However, there is a legal way to insider trade. It’s called front running.
As it turns out, front running is costing passive index funds plenty of additional gains during the year. It’s a big problem considering how big passive indexing has gotten over the years.
The question is, can active ETFs—with their semi-transparent and non-transparent structures—offer investors a way to nip front running and regain those lost returns?
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
Front Running in a Nutshell
Basically, the definition of front running is using insider information to buy or sell a stock ahead of the general public when information is being released. One example is buying shares of a defense contractor ahead of a major Pentagon win because you are buddies with a key Senator. Front running and insider trading are very much illegal and can come with harsh penalties from the SEC.
And there’s a legal way many hedge funds and big investors conduct so-called front running out in the open and through legal channels. It has to do with index rebalancing.
Despite owning wide swaths of the equity’s universe, market indexes aren’t static. They change and index providers rebalance these measures according to their underlying mandates. A small firm might grow too large for a small-cap index and be moved up to a mid- or large-cap index. A stock may no longer fit the definition of a ‘value’ stock and be removed from such an index.
The issue is that index providers generally telegraph what stocks are being included and deleted many weeks before the actual index rebalancing takes place. Until October 1, 1989, Standard & Poor’s policy was to announce changes in the S&P 500 after the market had closed, just before the rebalancing. However, since that date, S&P Indices has announced index changes well before. The reason has been to allow fund managers to prepare for the changes given the sheer amount of money now tied to index funds.
The bad news for index investors is that since we know what stocks are going to be added to the index ahead of time, people not tied to index funds can buy those stocks ahead of time, wait for the billions of dollars’ worth of index-tied money to flood these stocks, and quickly sell at a profit. And since indexes are required to own these stocks, we know that the gains are coming.
Costs a Lot of Coin
This index front running can hurt returns for investors as added costs and lost returns. According to smart-beta focused index provider Research Affiliates (RA), after index additions are announced these stocks outperform the market. Looking at historical data from October 1989 to December 2017, RA found that additions, on average, outperformed the market by 523 basis points over the period between the announcement date and effective rebalance date. Similarly, RA found that deletions—candidates for shorting—underperformed the market by an average of 429 basis points.
For index funds, this is a problem as they are now forced to buy stocks that have appreciated and sell those stocks that have depreciated. It’s buying high and selling low—the exact opposite of what you’re supposed to do when investing.
And the dollars are big. Altogether, RA estimates that the S&P 500 would have performed 22 basis points better per year if the S&P had not made the change in 1989. In actual cash terms, a University of Illinois study showed that index funds lose out on roughly $3.9 billion worth of returns thanks to rebalancing and front running. For a $2 million portfolio, that works out to about $29,000 per year in lost gains. When looking at it in terms of added expense ratio, the lost rebalancing gains can often be nearly triple the rock-bottom fee paid on most passive index funds.
What’s worse is the effect is even more pronounced when looking at small- and mid-cap stocks, as well as other inefficient areas of the market like international stocks.
Active ETFs to the Rescue?
But investors may have a way to beat back the loss of front running and potentially gain from passive’s headaches/losses. We’re talking about active ETFs. The win for active ETFs on this front is twofold.
For starters, thanks to recent rules changes, active ETFs don’t have to disclose their holdings on a daily basis. Depending on what kind of structure they choose—semi-transparent or non-transparent—managers can hide their special sauce from prying eyes and prevent front running in their portfolios. In fact, in non-transparent ETFs, creation/redemption baskets are done with assets and not the stocks themselves. With this, there is no buying ahead of an active ETF.
Second, flexibility of trades is a key win for active ETFs. Because they aren’t tied to an index or set rebalance date, managers can buy and sell as they wish. This means they have the ability to load up on stocks as rebalances are announced rather than on a set date. This can be especially fruitful if a manager already owns shares of a stock headed into an index and leads to additional returns. Likewise, they can find bargains from index castoffs and grab values.
These two key features of active ETFs might give them the edge to beat the market going forward. This could be particularly true in the large-cap U.S. segment. When combining lower expense ratios, ETF tax advantages, and the ability to avoid front running, an active ETF could make plenty of sense for investors.
Don’t forget to explore our Dividend Guide where you can access all the relevant content and tools available on Dividend.com based on your unique requirements.
The Bottom Line
Front running is a serious issue that has cost investors plenty of gains. But active ETFs could be the way to beat back the losses and regain some ground.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.