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No one wants an index that bears only a passing resemblance to the market it is supposed to represent. So most market participants applaud when an index provider makes big changes to its benchmark that lead to a more accurate representation of the underlying equity market.
But in practice such changes can cause headaches for fund managers, as they struggle to keep their portfolios in line with the moving target. Schroder Salomon Smith Barney has put together a report to help them find the most effective way of dealing with this type of upheaval.
Most of the changes that the major index providers are considering, or have already put into effect, relate to the adoption of free-float – or available market capitalisation – methodologies, the securities house says.
“Different indices have chosen different approaches as to how these changes will be implemented,” the report points out. Some indices are already free-float adjusted, such as the Dow Jones Stoxx and the Salomon Smith Barney indices. Several others – the MSCI, IBEX, DAX, AEX and others – are likely or certain to move to this type of methodology soon.
Possible strategies for a fund manager to adopt when a major index changes in this way include both cash and derivative solutions, the report points out, though most of these strategies have particular disadvantages.
If a fund manager chooses to do nothing in the face of an index change, waiting until afterwards to trade when appropriate then the portfolio could face quite a large risk against the benchmark. But if the manager opts to rebalance on the day of the index change, there could be excessive trading costs due to liquidity.
On the other hand, making a gradual change towards tracking the revised portfolio – which is only possible for fund managers who have no legal restriction on when they can trade – is likely to work better, say the report’s authors.
Possible derivatives solutions include buying a swap that is long on the stocks to increase in weight as a result of the rebalance and short on those which are to decrease. Another derivatives solution is to take long or short positions on countries, industries or sectors which should benefit or lose from the expected changes.
But the report illustrates in detail how fund managers can adopt a ‘dual optimisation strategy’. This involves optimising portfolios against both the current benchmark and a prediction of what it will be after the rebalance.
But what about minor changes to indices, such as when one or two stocks are added or taken away? In some sectors of the market, technology for example, the composition of an index can change radically over a year.
Stavros Siokos, head of portfolio trading strategy at Schroder Salomon Smith Barney, says fund managers with an index to track usually do one of two things when a minor change takes place in a benchmark.
“If they have enough cash they can use this to buy the added stock, or they can sell other stocks to fund it. Or else they can put money into futures contracts until they have the money to buy it,” he says. Selling other stocks can be a problem, but usually fund managers have enough cash on the side to finance the portfolio adjustment, he says.
Fund managers need to be on the lookout for upcoming index changes. “In some cases you can anticipate the changes, but in others you can’t,” says Siokos. With the CAC40, it is unpredictable, whereas with the FTSE 100, for example, adjustments are made at set times. All a fund manager has to do is look at the current market capitalisation of the component stocks to know what shape the revision will take and how it will affect their portfolio.
Sandy Rattray, index and derivatives strategist at Goldman Sachs in London, says that the way in which fund managers have dealt with minor index changes in the past is less effective than it was. The market has changed as active managers have started to become more conscious of benchmark changes, and it has become harder for speculators to make money out of index changes.
“Historically for fund managers there was a rule of thumb to buy early or buy late, and that would be profitable. That presumed that the stock being included would go up, but that has not been as predictable as it was in the past,” he says.
And when looking for a strategy to deal with major index changes such as rebalances, fund managers cannot simply look to past experience, because these changes are so far-reaching, he says.
The changes to the MSCI indices have been spread over 10 months. “MSCI’s methodology is very good at minimising the impact of these changes because they have effectively given fund managers the opportunity to spread their changes out over several months,” says Rattray.
“I expect there will be a gradual outperformance of those stocks going up in weight, so it makes sense to make your changes before MSCI puts them in the benchmark,” he says.

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