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COMMENIARY 64 JANUARY 2OO1

IS ELIMINATING TRACKING ERROR

HAZARDOUS TO YOUR CLIENT'S WEALTH?
As indexing grows, index changes are having an increasing impact on short-term price
movement in the underlying stocks. Many Plexus clients have seen costs skewed in the last year
due to changes in both the S&P 500 and the RU2000. Some have attempted to strategize trading
to reduce the impact of Effective date activity while others have stuck with prices near the close
to minimize tracking error.
Academic papers on the S&P 'game' have used mostly closing prices; only recently have papers
used intraday pricing.

provided for trading toward the close was to minimize

Summary
Using our 10 minute database, we find that:
. Stocks deleted from the indices show little
price change.
. Stocks added to the indexes show large
jumps between the close and subsequent
open after the change is announced.
. NASDAQ stocks show the most impact after
both the announcement and on the Effective
dates - with notable reversion after the fact.
. Broker intermediated stocks show the
greatest impact and reversion; this has a big
impact on the S&P400 and RU2000.
. lt is cheaper to be early, or even to be late,
rather than to trade at or close to the close
for NASDAQ and small cap NYSE stocks.
Late last fall we read a paper by David Cushing and
Ananth Madhavan on the behavior of stock returns at the
close, with particular emphasis placed on Market on Close
(MOC) orders.* The primary conclusions were:
. End of the day volatility has increased significantly.
. The large market caps show unusually higher levels of
volatility - partially due to more NASDAQ names.
. A higher percentage of liquidity imbalances has led to
increased close to ooen reversion.
tracking error: and the risk of negative tracking due to
premature trading exceeded the potential gains.
Not all index funds trade at the close, however. Many will
start to trade days earlier, basing their strategies on
historic observations consistent with both our findinos and
M ad havan/Cushino.
Price Adjustment on
Announcement Date
The NYSE has taken steps to reduce volatility for daily
imbalances by requiring MOC entries by 3:20 and the
subsequent announcement of order imbalances to
encourage public arbitrage.'
Despite changes. when Yahoo entered the S&P, the
Effective day mispricing and subsequent reversal
suggested that problems still exist. To test, we used our 10
minute orice database io iook at 40 additions and the
linked deletions from the S&P500 during 1999 to see if
there were consistent return patterns both prior to and
following the Effective date. [Yahoo was dropped due to
its skew on results.l We then isolated the changes by
exchange to see if the NYSE changes were helping
relative to the NASDAQ listings. Finally, we looked at
changes in the S&P 400 to see if the same pattern
appears in a lesser followed but smaller cap index.

The conclusions were consistent with observations that
we had made in the last year. Clients buying stocks on the
day they were added to the S&P showed increasing costs
over the course of the day. Similarly, clients rebalancing
the Russell 2000 also had increasing costs as trading
closed in on the Effective date (June 30). The rationale
Following the Safeway and AOL debacles in 1998, the
S&P stated that it would delay announcing additions and
deletions until after the close. Chart 1 shows eoual
weighted 10 minute returns relative to the open on the
Announcement date and the following day for additions
and deletions. Prices show no information leak: deleted
stocks rose 0.5% on the Announcement date. There was
no difference between NASDAQ and NYSE results, Price Adjustment on Effective Date
The next analysis focuses on the 2 day window when the
For additions, all the movement is between the Close on
stock is actually added or deleted f rom the index (Effective
Announcement day and the subsequent Open. NYSE
date). We look at returns over the day of the change, then
stocks rose 5.3% and NASDAQ's rose 7.8%. But look at the next day for signs of reversion.
following the announcement, stocks often reverted;
versus the open. NYSE shares fell 0.3% and NASDAQ's
Chart 2 again shows 10 minute equal weighted returns
slide back 3.0%.
relative to the ooen on the Effective date. The contrast
between the NYSE and NASDAQ
stocks is striking. NYSE stocks show
Price Change on Announcement Date little movement; there does not seem
10 minute lntraday views to be an imbalance of buy orders
9
forcing prices higher near the close.
r NYSE Adds NASDAQ stocks show a much
Changes anounced at
I the Close.
r NASDAQ Adds different oattern. The first half of the
7 day again appears flat, but as the
close approaches. prices rise.
6
Between 2 and 4 PN4 pric-os t'ose
o5 1.1"k, and between 3:30 and 4 PM
(E1+ No indication of pending orices rose 0.5%.
announcements prior to All of the price adiustment is at the
83 the Close. Open - with little follow through. No Contrary to the Announcement date
o-t significant impact on Deletions. pattern, prices revert between the
close and the next day's open.
1
NYSE stocks fell 0.6% and NASDAQ
0 stocks tell0.7%. Only 4 slocks rose,
and these were stocks that had fallen
-1
during the last hour of trading on the
-2 date. Once the oressure
Effective
was off, excess shares held in
anticipalion of additional buying were quickly sold off.
Over the remainder of the day, NYSE stocks recovered
Prices Show Modest Rise 0.2"k versus the open, but the NASDAQS lost an
additional 0.3%.
Prior to Effective Date
Deleted stocks do not show as dramatic a pattern.
Returns are flat over the actual deletion date with little
Prices fell after the announcement but did not stay down.
subsequent close-to-open reversion. As with the
Between the close on the day {ollowing the announcement Announcemenl returns, the actual deletion does not
and the Effective date, NYSE stocks rose 0.5% while appear to create any appreciable imbalance.
NASDAQ's rose an average oI7.2k. Announcement-to-
Effective date can vary from stock to stock, but it would What about other lndices?
seem that buying after the initial news settles in would
have been orofitable. To determine whether the Announcement and Effective
return phenomena were isolated events in a few S&P500
Deletions from the S&P show little impact. There was names, we also looked at 48 additions to the midcap
no discernable Close-to-Open move. The average and S&P400. A comoarative table is included at the end.
median returns were flat. The average deletion
declined 0.5% after the open, bul was skewed by a few The same patterns appear:
names. The median price actually rose +0.1"k. Nor . Minimal price movement prior to the announcement;
was there any additional pressure between the . A significant overnight price adjustment;
Announcement and the Effective dates. Holders of . Excessive price change late on the Effective date;
these names were not compelled to sell immediately, . Large overnight reversion once the stock goes into
and there was little to be gained by shorting in the index;
anticipation of index selling. . Deletions (there were also 48) show little return change
on either the Announcement or the Effective dates.
 But we also f ou nd that
nange on Effective
Price Cha Efiectt' Date Deletions NASDAQ prices gradually rose
10 minute Slices O NYSE Adds
between the Announcement
r NASDAQ Adds period and the subsequent
Demand imbalance on
Fffcclirra dav Clnca ic eaan in
Effective date. Further, the
NASDAQ stocks - but not in Close to Open reversion is signiicant
nearer the trade was to the
close, the greater the price
1.5
I NYSE stocks for both NASDAQ and NYSE stocks.
Again, no impact for Deletions. impact. NYSE stocks appear to
,
be well behaved, but stocks
1
f,r
I ,/, with higher levels of
! I
intermediation show the
t 0.5
I
'l *- greatest impacts and
rJ subseouent reversion.
'i
It0 -_ - lrtfr'l*-+L-
o\
The reversion aooears to be
-0,5 .11 -. greatest for stocks with the
I l.- -tajaaa.fa most movement atler 2 PM.
I
Stocks that weakened actually
- Effeeiilire date +1
rose the next day - this is a
E*ectivb aare -
paitern aiscr noied by
MadhavaniOushing. But also
note that the NYSE stocks were
not f u ly immune f rom reversion; it appears that even
The S&P 400 stoc<s are smaller caps and. corsequently, these stocks had some excess speculation in them that
suhrect to orea-er dealpr snecialist inte .^rcdiation tnan are
was released once the Effective date oassed.
the S&P names, The greater the dealer intermediation,
the greater the impact when there is a knowable liquidity
imbalance, This s a pattern that has repeated itself for the The observations suggest a strategy that puts an
new RU2000 names each June 30, leading to large costs emphasis on trading early on the Effective date, or
for those who trade on the last dav. waiting until some time after the fact. Trading late in
the day is, in general, the most expensive route. But
The orrestion c rl,np-he r iho natiorn hohrroon announcement there may be times when price deterioration prior to
dates and Effective dates warrants alternative trading the close due to excessive speculation provides an
ctratonioc n' ,r,ho-ho. desks are irrst as wcll off tO tfade at the opportunity for prof itable trading. Note that these are
close to elimrnate tracking error. We have shown that the the exceotions. not the rule,
S&P's dec sion to not announce deletions and additions until
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The nriman, nrir:e an ..strent occ. trs ovcrninht. But note that
''*')Y'vvv|'||Y|| .Cushing, D. Madhavan, A., Stock Returns and Trading
the adjustment also appears overblown, waiting for a day
provided,aroe bene{its at the Close. Working paper Nov. 1999.

2-day price Changei for S&P 500 and

S&P 4A0 additions.
s&P400 S&PsOO NASDAQ
only
Announcement:
D0 Open>Close +22 bp -23 bp +5 bF
D0 Close>Dl Open +441 bp +615 bp +783 bp
Dl Open>D1 Close -13 bp -124 bp -299 bp

Effective:
D0 Open>2 PM -r vP +25 bp
2 PM +3:30 +83 bp +31 bp +71 bp
3:30 ;Close +7? hn +15 bp +44 bp
D0 Close>Dl Open -257 bp -58 bp -64 bp
Dl Open;Dl Close +44 bp rA hn -25 bp