Evil Diaries: Goodness Gracious Me! (Goodness was nothing to do with it)

Jackie Alexander of Alvar sent on this snippet about ETF’s which was posted somewhere on Thursday. She said that I might find it interesting. I trust readers also find it interesting.

I mention that my chum, Alan Miller, is a shrewd and informed man who runs SCM Direct, which is confined to ETF’s, since he is extremely sceptical of the advantages of spending money on fund managers to pick stocks. I do not share his view. But fixed rigid rules obliging ETF managers to lay out their clients’ cash make no sense to me.

“In the early 2000’s a stock called Dimension Data was listed on the UK main market. At the time of listing the company was due to go into the FTSE 100 index based on the closing price on 31st July 2000. Almost all (if not all?) the index funds knew they had to buy this stock on the 31/7/2000 closing price. There was very little leeway with timing, due to the way the index funds worked. Various funds place their closing orders around various different trading houses. But instead of the funds paying commission for their trade to be executed. they were being paid for the order by the trading houses! The logic being if you had an order to buy (say) 100 million shares at the closing price any trader could make money out of that. It was worth paying £5mil for that order! A few houses started buying throughout the day, maybe 40% of the order, and put a closing order in for (say) another 30% with the intention of driving the price high, filling the fund at the artificially high closing price and shorting the remain 30% of the order at this close. Dimension Data went from £6.50 to a close of over £10, only to open the following trading day at £6.30 The sums involved were about £10m of profit for prop desks around the City. And the losers who paid this? The man in the street through his pension fund ,ISA or tracker.”

Tom Hayes remarks:

“This seems to be a classic case of a carefully thought out rule that inevitably was subject to its weaknesses being exploited. The reality is that for large orders, particularly spread across the street and so conspicuous and all in one direction either a fee or some acceptance of pre hedging is inevitable, that’s the only way to handle those orders. The difficulty arises in that the agreed price is the closing price and that’s open to dealers operating within the rules legitimately maximising their profit and loss. It would work better if the price was for example the volume weighted average price for the day. That would also stop dealers taking shorts at the very high at the close. I guess the way I look at these things is that if you don’t like the rule or process then change it but equally people do need to accept liquidity costs money and larger liquidity larger money. I suppose often in real life that’s a “hidden” cost for most things people buy and sell. But in markets it’s not. In all honesty though I can’t blame the dealers here, they are just doing their job!”