Where Bloomberg Discovers That Large Orders Have Market Impact

In my former life, my trading desk made a lot of money trading around index-related flows. My bosses were amongst the first to grasp the impact of index fund demand and how it would affect the prices of the underlying stocks. As a result, we were able to make such index-related trades a very profitable part of our business. Over the years, of course, the “knowledge” made its way into the market, and the number of market participants willing to take these trading risks increased, which decreased the profitability and increased the risk of the business.

Today, the business is massively “marginalized,” (I mean, I was shocked to see that Charles Schwab is even marketing index-related trades to their retail clients!!! ) to the point where most of the impact is usually priced in very quickly – an effect you can observe by noting that frequently there is very little price impact at the actual benchmark time of the index change.

Which brings me to the article which prompted this post: Bloomberg’s Yuji Nakamura’s “The Hugely Profitable, Wholly Legal Way To Game the Stock Market.” This post struck a nerve with me because it portrays index funds as the victim of nefarious market evildoers like “hedge funds” and “Wall Street trading desks.”  Reality is the opposite. Let’s get into it.

The article begins:

“It’s an easy way to game the stock market, and getting easier by the day.”

Well, it’s the first sentence and the author already has it backwards. The business of pre-trading index related flows used to be an easy business! When few people knew about the flows or understood them, it was very easy for us to go out and buy the names that were going to be added to, say, the S&P 500 index. We’d have relatively modest impact, since we weren’t competing with thousands of others trying to put on the same trade, and we’d accumulate a position that we’d then sell back to the index fund at the time of the index inclusion.

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