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 On Friday, Russell will announce the names of some 128 companies
that it is adding to its widely-followed Russell 2000 index of small
companies. And that’s when the big index fund providers – including
Vanguard Group, Dimensional Fund Advisors and BlackRock Inc <BLK.N>
- must adjust their portfolios by buying the new stocks and selling
the old.
As recently as three years ago, big brokerages such as Bank of
America Merrill Lynch <BAC.N> and Goldman Sachs <GS.N> would vie for
those orders, confident that they could hand the big fund companies
discounts of around .05 percent off of market-priced trades and
still make money, mainly by stockpiling the right stocks in advance
of the big trade.
But in recent years, that has become harder to do. With FTSE Russell
disclosing probable additions and deletions in advance, as well as
increased competition from other institutional and retail investors,
brokers have not found reconstitution day delivering the easy money
it once did.
Now, most brokers are offering the index funds closer to .01 percent
to .02 percent, current and former executives at brokerage firms and
index fund providers told Reuters. All of the executives wished to
remain anonymous because they are not permitted to speak to the
media.
"The brokers are finding it is not as lucrative as it once was,"
said one index fund manager.
There is big money involved. Roughly $835 billion is invested in
index funds that track the Russell indices, Russell said. More than
$50 billion is expected to change hands in the final moments of
Friday, according to New York-based Investment Technology Group.
For example, at BlackRock alone, $41.9 billion in funds track the
Russell 2000 index. With about 10.7 percent of those indexes
expected to turn over, brokers would pay between $450,000 and
$900,000 for the privilege of doing those rebalancing trades - and
more to trade for the BlackRock institutional portfolios that also
track those indexes. In the era of 0.05 percent discounts, brokers
might have paid $2.2 million or more to BlackRock to handle the same
volume
Brokerage firms typically start buying shares of the companies that
will be added to the Russell indices earlier in the year in
anticipation of being able to sell them at a profit on the rebalance
day. That was a more lucrative strategy when it was harder to figure
out which companies would be added.
Trading off the rebalance months ahead of time is so popular that
Charles Schwab Corp has even promoted the strategy to its retail
investors.
"If you're a short-term trader, you might want to take advantage of
the Russell reconstitution by buying some of the possible additions
around the end of March and selling them near the end of June,"
Schwab wrote in a March 2014 paper promoting its equity rating
service.
A Schwab spokeswoman declined to comment.
As a result, these shares are popping months before the
reconstitution and then losing ground on the big day.
For example, Reuters analyzed the price performance of the 10
companies that saw the biggest volume boost on the day of the 2014
rebalance. Those shares rose 8.3 percent in the three months leading
up to the rebalance, while the Russell 2000 Index rose 2.2 percent.
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On the day of the rebalance, they fell 3.9 percent, while the
Russell 2000 rose 0.7 percent. They slipped another 10.3 percent in
the subsequent three months, while the broader index lost 5.9
percent.
FTSE Russell has made several changes to its methodology over the
past several years and made the process more transparent to reduce
the volatility in these stocks on the day of the rebalance, said
Rolf Agather, managing director, research and innovation indexes at
FTSE Russell.
Goldman Sachs, BlackRock, Vanguard and Dimensional Fund Advisors
declined to comment. Calls to Bank of America were not returned.
A CROWDED TRADE
Another reason brokers connected to big banks are less likely to
offer the aggressive price improvements they once did is the new
post-financial crisis regulations requiring banks to keep more
capital on hand, executives said.
"A lot of firms are reluctant to put their balance sheet out these
days," said one of the brokerage executives, explaining that by
buying up the positions in anticipation of the rebalance, they are
essentially increasing the amount of risk on their books.
For brokerages, the desire to win the index fund business while
managing risk puts them in a difficult spot. On one hand, they want
to offer competitive pricing, but on the other, they need to manage
their own risk.
"Firms understand this business is a loss leader but the hope is the
relationship grows and the broker does other business with those
managers," said Peter Kenny, chief market strategist at Clearpool
Group in New York.
For example, large index funds can pass on brokerages business from
their institutional clients, which is highly lucrative, said one of
the executives who works at a large Wall Street bank.
That makes it difficult for firms to stop offering these discounts
altogether.
"The index funds have a lot of power right now," said one former
brokerage executive.
(Reporting by Jessica Toonkel.; Additional reporting by Chuck
Mikolajczak, David Gaffen and Rodrigo Campos; editing by Linda Stern
and John Pickering)
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