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What You Don't Know

What is Index Arbitrage and How Can You Use It for Your Own Investing?

02/14/2019

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Front running is not a term that the average investor ever discusses or even really needs to understand. This is because front running is actually illegal. The term front running generally refers to something that is done by investment professionals to gain an unethical edge over the average retail investor.
However, there is a form of front running that is allowed within the investment community. This act of front running has to do with the way that index funds operate and how savvy investors can use that information to their advantage in order to grow their portfolio or avoid losses.
This article will discuss front running and how index funds allow for a form of front running that is not currently illegal. Understanding the details of these concepts, at the very least, can help make you a more knowledgeable investor as you choose the investment options that are right for you.

What Exactly is Front Running?

Front running is a term that many investment professionals will hear about as they go through their education and certification requirements. The general takeaway is that front running is illegal, unethical, and unprofessional.

So, what is front running? This is when an investment professional learns about trades and then submits their own order to beat the other trades to market. Depending on the size of the trade being made, people who engage in front running could have a unique advantage in the market – which is why the act is illegal.

This makes perfect sense, and the rule against front running is designed to level the playing field for all investors. Theoretically, investment professionals could be dealing with several major clients and have access to trading information before it is even entered. This is information that average investors do not have.

Therefore, it is the responsibility of investment professionals to enter their trades after they have entered the trades of their clients. This simple rule avoids any ethical or professional violations that could result from front running.

When is Front Running Legal?

If you are operating by the strict definition of front running, then front running is never legal. However, with that said, there is a type of front running that some may or may not refer to as actual front running.

On the surface, this looks like front running and may give similar advantages to front running, but it is really just good market timing by clever investors. Of course, that’s a long way to explain the concept so it often gets referred to as front running for simplicity.

How does this legal form of “front running” operate? It all has to do with the fundamental construction and operation of index funds. These are funds built to track the specific movements of an index using the same stocks that comprise an index like the S&P 500, for example.

When these indexes make changes to the stocks that are tracked as a part of the index, they announce the changes several days before the change is actually implemented. This is a signal to index funds that they may have to rebalance their holdings by selling and/or buying stocks to ensure that they are accurately tracking the index they were designed to track.

This creates a buying or selling opportunity for investors as they prepare for major market movements caused by massive index funds buying or selling certain assets on a specific date. As a result, this type of front running is more accurately referred to as index arbitrage. Investors use predicted market changes to take advantage of short term changes in price.

How Does an Index Arbitrage Work?

As you can see, an index arbitrage looks a lot like front running but, since the information is available to all investors, it does not meet the technical definition of front running. However, the advantage is very similar and it can be used by savvy investors to make great short term gains.

As an index fund changes the assets they track, they must announce these changes. The announcements are made up to a week before the changes are actually implemented. As a result, investors have ample time to go ahead and make investment decisions based on upcoming changes.

For example, if an index is going to be adding a stock for tracking, then it can be assumed that the index funds that track that specific index will be buying the asset for their holdings. This kind of massive buying pressure can cause stock prices to rise rapidly. Savvy investors that are aware of this change can purchase the stock on the day the change is announced and then sell at a profit when the index funds enter the market to adjust their holdings.

On the other hand, if a stock is being removed from an index then this may be an indication to sell holdings before selling pressure increases greatly due to index funds relinquishing their holdings – driving the price down.

Making the Market Work for You

Front running is illegal for good reason. The advantage is not fair to retail investors who do not have the same information. However, index arbitrage is totally legal and a great way to use the massive movements of index funds to your advantage.

Understanding the roles of index funds, how they can affect the market, and how to use this information for yourself can be like getting a front running advantage – without the legal issues that come with actual front running.

To learn more about index funds, how they work, and how you can use index funds to your advantage even if you don’t invest in them, contact Linden Thomas and Company today.

Linden Thomas & Company

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At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

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