Timing is Everything: How Index Investors Create Arbitrage Opportunities

Why It Matters

The surge in passive investing has made global stock indices powerful market movers. Yet the rigidity of index-tracking funds around index rebalancing dates creates predictable price patterns. This opens the door for arbitrageurs to profit, raising questions about market efficiency and the hidden costs of passive investing.

Key Takeaways

• MSCI index reconstitutions create systematic price distortions that arbitrageurs can exploit.
• Index-tracking funds’ insistence on minimising tracking error drives abnormal returns and trading surges.
• Arbitrage profits are higher in Asia-Pacific and emerging markets compared to North America.

When Index Rules Move Markets

Stock indices such as MSCI’s are routinely updated to reflect changes in company size and market conditions. This means some stocks are added while others are removed. With trillions of dollars benchmarked against these indices, the changes have immediate and predictable effects.

The study analysed MSCI reconstitutions in 56 markets worldwide between 2006 and 2023, covering more than 3,500 stock additions and deletions. It found that stock prices and trading activity spike around the effective dates of index changes, particularly on the day before the changes take effect.

Index-tracking funds, aiming for zero tracking error, typically wait until the last moment to adjust their portfolios. This predictable behaviour creates price pressures that nimble traders can exploit.

Arbitrage in Action

The research shows that arbitrageurs can earn significant returns by anticipating these moves. The most profitable strategy: buy stocks that are about to be added and short those about to be deleted immediately after the announcement, then close the positions the day before the change becomes effective.

On average, this approach yielded abnormal returns of around 5.4%, even after accounting for the costs of borrowing shares for short selling. The intraday analysis revealed that much of the price movement occurs in the final hours before the index change, with as much as half of the day’s trading volume concentrated in the last minute.

Notably, the opportunities vary by region. Asia-Pacific and emerging markets showed stronger price distortions and higher arbitrage gains, while North America displayed weaker effects, suggesting its investors rebalance earlier and more flexibly.

Why Rigidity Matters

The findings highlight a tension in modern markets: index-tracking funds prioritise minimising tracking error over trading efficiency. This rigidity creates costs for investors and opportunities for arbitrageurs.

The study also documents sharp swings in equity lending around reconstitution dates, reflecting heightened demand to borrow shares for arbitrage trades. Over time, arbitrage activity, particularly short-selling of deleted stocks, has grown, fuelled by deeper lending markets.

Business Implications

For asset managers, the research underlines the hidden risks of mechanical index-tracking strategies. While marketed as low-cost and efficient, passive funds may be leaving value on the table and indirectly subsidising arbitrage profits.

Regulators and exchanges may also need to consider whether index methodologies unintentionally destabilise markets by concentrating trading activity into narrow time windows.

Meanwhile, arbitrageurs and active managers have clear incentives to monitor reconstitution calendars closely. The predictable flows of passive funds present recurring opportunities to capture short-term profits.

Authors & Sources

Authors: Xin (Simba) Chang (Nanyang Technological University), Jiang Luo (Nanyang Technological University), Jiaxin Peng (Capital University of Economics and Business), Shuoge Qian (Singapore University of Social Sciences), Choon Wee Tan (Advance Capital Partners)

Original Article:  Pacific-Basin Finance Journal