Index Front Running: What happens when a stock is added to an index?
Recommendation on How to Implement This Strategy
The whole market is a very chaotic thing. The way that chaos is being controlled is through different indexes. Those indexes represent the synthetic indicator of the movement value of a defined set of securities. It is actually a way to calculate the performance of different things on the market such as investment portfolio…Every market in the world has at least one index, and in most cases, there are a lot of different indexes. Also, it can happen that the same index is present at multiple markets. Indexes can be classified in many different ways. For example, an index with wide bases represents the performance of the whole market of shares and giving a picture of ongoing things in that economy. Some of the most popular are the Dow Jones Industrial Average and the S&P 500. Also, there are “nonlimited” indexes which are not limited to individual exchange markets, the most popular ones are Dow Jones Wilshire 5000, EuroStock 100… Also, there are indexes that are specialized for certain fields on the market like the Morgan Stanley Biotech index which includes 36 American companies in the biotech sector.
One of the main divisions of the index is by the way they are calculated. There are two types of indexes, the first one is only calculated by the price of the share, and the second type is calculated with many different factors, which can be the size of the companies, the exchange rate of the domestic currency, the value of the market…
There is one more important thing about the indexes. If the stock itself is added to the index it means that stock becomes, some sort of, “elite” one which will be quite hard for buying in the next period, but it has constant growth.
How Does This Strategy Work?
One of the most important things for stocks that are added to the index is anticipation. In other words, to buy that stock before other traders do, and to anticipate the addition of that stock to the index.
One of the strategies could be a passive way of investing. More concrete investing in passively managed funds, which can help you to track all the necessary indexes. Some studies have shown that investors who were investing passively gained shares from those doing it actively, and there are some indicators that this trend will continue.
Also, passively managed funds give you the better look at the market. Since your capital is constantly there, it is easier to track market movements and to act proactively. Also, it is a lot easier to spot any possible error that could occur, by doing it this way.
Next thing is that passively managed funds will be forced to buy at a predictable time, which means that you have a nice and profitable trading opportunity. The main problem is that those passive methods must minimize tracking error but also they must not make too much trading costs.
What Does the Data Show?
A way to check and to prove your strategy is to see what will date shown. This can be done through charts and analyzing your stocks that you have invested in via different indexes such as the S&P 500.There you can see a clear picture of the performance of your strategy.
In the summary of this whole strategy, there are some factors that you should have on your mind.
First of all many research lately shown that the impact of index addition isn’t that what it used to be. In other words, it is not that strong.
Second, some of the investors are aware of these movements, and some of them changed their ways of investing. Now, they are trying to accumulate slowly before or after the addition of the stock to the index, and by that to avoid trading costs of passive methods as well as higher tracking error.
Nevertheless, this way of passively investing is still proving useful. The mindset of minimizing tracking error, and delivering the index return, ignoring the higher trading cost is still more profitable than just acting at the sight, and buying the stock at the moment that it is announced. Also, the best way of doing the “active” method of investing is to buy the stock at the moment that it is announced, or shortly after it, which is, as it sounds, very hard. In just a few hours the price can go quite higher than the starting one, and soon can be added to S&P 500, in other words, if you don’t act at the proper moment, while doing the active way of investing, it can be a disaster.
Why is This Strategy Still Profitable?
While the market has always been an uncontrollable entity, the indexes are some sort of guardian which maintains order. The first thing you need to know is the very nature of the index. By which it means that you know, which type it is, is it for the whole market or just for one segment, is it on multiple of just on that individual market, and at the end how is it being calculated (based solely on price or there are some other factors). Also, you should know some of the most popular indexes such as the S&P 500. After this, you need to know what it means for stock to be added to the index (which means that stock has just become an elite-top one), and then to form the strategy. Two main approaches are to this strategy, which is active and passive. For stock addition to index it is better to use the passive one, since the stock is been added to index when it becomes an expensive one, and that is the thing you want to anticipate. Also, you have a better overlook the market while using the passive method. There are also disadvantages to the passive way of investing. You have to always be aware that your main goal is to minimize tracking errors, because that is the “main mission” of the passive approach, and you must be careful when it comes to trading cost, since it can be higher if you avoid buying a stock on sight.