How to arbitrage equity indices
People - Investing
Thursday, 04 October 2007 09:05

Many ETF's and mutual funds try to track an index, for example one of the MSCI indices. When a stock enters the index many asset managers buy the stock. Since so many asset managers do the same the stock goes up as soon it joins one of the major indices.

But some investors know that this will happen as soon as a stock joins a major index. They try to predict this and buy the stock just before it is announced which stocks are added and removed from the major indices. See also this article.

You don't believe this ? Here is an example. On September 26, 2007 Standard and Poor's said that it will make changes to its Midcap 400 index. The companies joining the index all replaced companies that were acquired by other companies. The new companies were Corn Products International and Getty Images (GYI). These companies went up a couple of percents the day after. Within a few days investors took their profits and the stocks went down again.

In addition S&P has announced that a number of companies will move to the Smallcap 600 index. These companies went up as well after the announcement.

Especially the fact that Getty Images went up can not be a coincidence. This stock went down in July and August after a profit warning and in September 2007 after another analyst downgrade. It went down even during days that the rest of the markets were up. Only thanks to a couple of acquisitions of other companies in the S&P's Midcap 400 this company made it to this index.

The question is whether you can play this index arbitrage game yourself. Here is what you need:

  • You need money, index arbitrage triggers higher trading costs that buy and hold strategies. You may consider borrowing this money, for example using a margin account.
  • You need time because it is time consuming to find, trade and monitor the stocks that will join the index.

You also need to decide about which index you should arbitrage. Once you have decided which index you are going to arbitrage you need to study how that index is composed. Below you find links to the methodologies of the major indices:

These indices typically contain a fixed number of companies. The order of the companies in the index is often based on market capitalization. At least the biggest indices are based on market capitalization and these indices are the easiest to arbitrage.

So first choose an index that is based on market capitalization. Then you can identify the company with the smallest market capitalization in the index you have chosen. This is the last company in the index. The next step is identify other companies that have a market capitalization just below these companies. This looks more difficult that it is. If your index is the S&P's Midcap 400 you should first look at number 400 of your index. Then take the list of the S&P's Smallcap 600 and find the number one on the list. Compare the market-cap of these two companies and their growth rates. Determine the dates on wich the index is reconstituted and on which the announcements are made and buy the number one and maybe also the number two and three of the S&P's Midcap 600 just before these dates. Make sure you sell the stocks after the reconstitution.

You can also work with call options to get a higher leverage. If you do this all year, for other indices as well, then you will probably have high returns while still being liquid most of the time.

An ideal tool for computing the return on investment from short term investments is this calculator.