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Three Observations

Three Observations - August 2022

1. Intellectual Property

This Bloomberg scoop about a pair of Goldman traders who left Goldman’s “Index Arb” team only to find their former employer threatening suit, feels like a concerted effort to get on the right side of public sentiment. The optics harken back to the story of Sergey Aleynikov, who left Goldman in the early innings of the HFT boom in the aftermath of the Global Financial Crisis, purportedly with intellectual property in a thumb drive, only to be promptly convicted of stealing trade secrets.

Today’s story has to do with the modern version of high-frequency trading: index rebalance arbitrage. It is increasingly coming to light how profitable these trades are, and it is no secret that its practitioners are in high demand.

2. Trade Intercept

The strategy is conceptually simple: identify market participants who participate informationlessly in their trading (e.g., index products). This identification can come from reading prospectuses and understanding index rebalancing rules. This process can be complicated and probabilistic. But in its simplest form, front-run the trade you deduce is happening, watch as gigantic order flows fill the rebalancing trades, exit with "risk free" profit.

The strategy has grown in prominence alongaside the ascendance of ETFs. These products are championed because of their combination of greater transparency and low fees in a marketplace always harangued by compensation talk. The result has been huge dollars flowing into predominantly passive ETFs.

This paper by Sida Li at the University of Illinois, Champaign, purports that rebalancing arbitrageurs skim roughly $3.9 billion a year from the $7 trillion passive ETF market. The Bloomberg Article quotes Goldman’s profits in the activity at $600 million (seemingly high?), revealing the stakes at hand. The paper is quite interesting in its decomposition of the specific rules that different types of ETFs use with regard to their index constitution and the implied price impact that each see.

3. Customer Welfare? Payment for Order Flow All Over Again

Your author anticipates a Flash Boys type uproar over this activity. Don't worry, it will probably take another 3-5 years, by which the trade will largely be benign/exhausted. This aligns quite nicely with the ark of events surrounding high frequency trading, its evolution into modern market making, and the current uproar surrounding payment for order flow.

In both cases, consumers can purchase financial services at subsidized costs: for PFOF, we are talking zero commission, Robinhood trading. For Index arbitrage, we are talking about zero-bound management fees for index ETFs. Why the analogy? Well, one can’t expect the cost associated with conscientious trading to occur in products where the marketplace effectively rewards reducing marginal cost to the bone in order to market oneself as the low cost provider. The marketplace adapts to what selles, and headline management fee is the name of the game. We wrote a corolarry to this some years ago.

The kicker: Li's paper suggests that trade execution shortfall for these ‘lazy trades’ might cost in excess of 60% of the headline management fees. Be careful what you pay for!


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