Grégoire Thomas - Mastering Index Arbitrage

00:00:06 [Grégoire Thomas]
And I think for index rebalancers who are there for the long run, the models need to be more and more sophisticated. And all the time we need to work a lot on our R&D to make sure that we take into account new factors that actually start having an impact on the strategy itself.
00:00:27 [Vincent Weber]
Welcome to Resonanz Spotlight, where we explore investment strategies and meet the experts who bring them to life. I'm your host, Vincent. And today we are diving into a strategy that operates quietly yet powerfully in the market, index arbitrage. In an era dominated by passive management, index rebalancing events create ripples through the financial market that few truly understand or capitalize on. For institutional investors managing substantial portfolios, understanding these dynamics isn't just academic. It's crucial for optimizing execution and identifying new opportunities. Our guide through this complex landscape is Grégoire Thomas, head of equity market neutral at Candriam, where he leads one of the industry's most established index arbitrage strategies. With experience spanning from Millennium, Bank of America and Societe Generale, Grégoire brings unique insight into this specialized field. Grégoire, welcome to Resonanz Spotlight.
00:01:24 [Grégoire Thomas]
Thank you, Vincent.
00:01:26 [Vincent Weber]
So let's start with the fundamentals, Grégoire. Could you walk us through how index arbitrage capitalizes on market inefficiencies and what are the core mechanics that make this strategy effective?
00:01:39 [Grégoire Thomas]
Sure, Vincent. To start with, an arbitrage is entering into a position where you buy one asset and another asset because there is a valuation discrepancy between those assets. And index arbitrage is entering into an arbitrage between an index product, an index future and an ETF, for instance, or an index future and some index baskets. And the idea behind that, and when I talk about index arbitrage, I'm going to focus specifically on index rebalancing. The idea is that there are in the market price or valuation discrepancies that you want to capture. And when we talk about the index rebalancing, what happens there?
Basically, when an index is maintained by the index provider, there would be times when the index provider would say, well, this stock has to be added to the index, so that's an addition, this stock has to be deleted, so a deletion, or the weighting of the shares is going to change. And all those events that are announced by index providers, they will drive significant rebalancing flows people buying or selling the constituents and this creates a price discrepancy that we aim to capture in our strategies and this price discrepancy is actually caused by the liquidity need of the market which needs to buy a stock or sell another stock in anticipation of the flows So that's the core principle or the core idea behind index rebalancing.
It's the idea that you can anticipate that in the future they would be buying flows or selling flows on certain constituents. And then if we take a step back, those flows can have very different reasons. It could be because there is a corporate action merger between two constituents and therefore the index will change. It could also be because some stocks will be delisted from an exchange and released at another one. Again, this means that the stock would be delisted and therefore deleted from one index and added to another index. There are multiple reasons why there are many index rebalancing during the year and for each of those rebalancing, there is an opportunity to put a trade on and to capture that price impact.
00:04:02 [Vincent Weber]
So we've seen passive management reshape the investment landscape over the past decades. And how has this shift influenced the opportunity setting, index up, and what new dynamics around it should investors be aware of?
00:04:20 [Grégoire Thomas]
Cool. Yeah, if I take a second and I talk about passive management. Just to put some figures around that, that passive management, which is defined as those funds that are aiming to track an index passively without any active decision-making. So the first fund was launched in the 1970s, so more than 50 years ago. And what's interesting is that, as the industry around passive management has grown over the years. The promise of the passive funds is to offer a cheap way to track the market to the retail investors. And it has been very successful. It has been successful up to a point where the AUM of passive funds in the US has become bigger last year, at the end of 2023, bigger than the AUM of active management.
So it's really a driving force in the market. Passive management has grown tremendously from nothing in the 70s to more than 50% of the AUM in the US. In Europe, the current ratio would be 40% for passive management. So it's a massive shift in the investment landscape, and it has impact because those funds, as I was telling you, are trying to replicate indices. So whenever there is a rebalancing, a change in the constitution of an index, those funds would need to buy or sell the constituent in the right proportions. And it means that they require a lot of liquidity whenever a stock is added or a stock is deleted. And the index rebalancing strategy is a way to provide that liquidity to the plastic manager and to get paid in exchange of that.
It's another way of looking at index rebalancing. You could see it as a way to say, well, there is going to be some outperformance of stocks being added and underperformance of stocks being deleted. But you could also see it as, well, there is so much liquidity that is needed by the passive manager that I'm going to provide the liquidity in a way like a market maker, and I will be paid because I will carry some risk on my books, and I will be paid for that service of providing liquidity. And so, again, coming back to your question of There has been a massive shift. Yes, passive management is a dominant force in the equities market and it has impact in the market. And how has it transformed the business of index arbitrage or index rebalancing?
Well, I would say the sheer scale of passive management means that there is more and more need for liquidity. So another way to say it is the price impact of passive management is becoming bigger and bigger. And one example of this would be Tesla four years ago. I think we discussed that. But just to give you the figure on the inclusion of Tesla in the S&P, there was a need for which represented 23% of the outstanding shares of the company on that very day. And so how does it impact strategies like index rebalancing? Well, it means that We need to be much more accurate in the way we predict how much volume in a trade.
We need to be much more accurate in how much volume has already traded because passive management has realized that its impact is very big. So some of the fund managers have adapted the way they implement the rebalancing. And we also need to take into account how many investors would implement an index rebalancing the way we do it. Basically, the increase of the size of passive managers means that more and more investors like ourselves have become aware that, oh, there is something to do here, there is some liquidity to provide, some outperformance to capture. And so we need also to take into account how much they represent in the overall trade to make sure that we don't get the trade the wrong way. Because sometimes you would have people overplaying the trade.
00:08:35 [Vincent Weber]
I like the example of Tesla you just mentioned. Could you give us some more color on that? Because how you approach it, how you try maybe to anticipate flows without giving away your secret sauce.
00:08:52 [Grégoire Thomas]
Tesla, again, was really a landmark example. So we were in 2020 and for different reasons, which are technical. Tesla became eligible to the inclusion into the S&P 500. And I say technical reasons because you have to understand that indexes are usually rule-based. It means that there are predefined rules and a methodology for each index that explains how the index is going to be computed, how the index is going to include or not include some constituents. And all those rules are well advertised and published by the index providers. And so TESTA became eligible to the inclusion in the S&P 500.
And it was very well announced and flagged in advance because the way it works is that the index provider would announce on a certain date that in the future, on a specific date called the rebalancing date, the stock would be added or deleted. Tesla was announced to be added and at the same time another company was supposed to exist. So basically, you have all the information in advance. And so before the inclusion, we knew that Tesla was going to be the biggest addition to the S&P 500. We did our research. So the way it works, at least for us, is that our investment process is quite consistent. We want to be consistent because we are facing all those events during the year.
we know that by being regular in the way we approach them we can get rid of any bias for instance for our start sorry no subjectivity in the way we invest and so we write our competitive analysis on that scenario on pesa being added with all the data that was already provided by the provider and we came up with a purely quantitative proposal what we do in in our way of implementing rebalancing is that we not only look at the quantitative aspect of it, but we also add a fundamental analysis of the different positions we would take. So here that would be Tesla, a hedge, which could have been the S&P 500, but actually in the basket, we also consider the stock being deleted.
So after the quantitative analysis, we run a fundamental analysis on the different stocks we want to take position on, trying to identify potential biases. potential risks which would not show in the quantitative analysis. And we end up with a proposal of the transaction that we then size, time, and then that we enter into. And I would say, coming to what happened, so after the fact post-trade analysis, if you look at the price performance of tesla you would see that tesla between the announcement and the inclusion had a massive outperformance of 30 and then after the inclusion and some underperformance which was also quite significant and so it's really a textbook example of an index redundancy going right going the right way which afterwards gave the idea to many participants which who are not involved in
index rebalancing, that there was something to do here. And I'm going to mention another S&P rebalance, which is the S&P rebalance of two months ago in September. Actually, the biggest S&P rebalance since Tesla. So it's quite interesting because we're going to contrast those two examples. So two months ago, you had, again, because of some technical reasons, some price increase, some methodology change of of the S&P rules. And as a consequence, you had a very well flagged and advertised weighting increase of Apple. So it was very well advertised that Apple would see its share in the index increase by a fair amount. And there was 30 billion US of the stock to be traded on the closing price.
So again, you would say, well, if I apply the textbook index rebalancing methodology, then I should buy some Apple, sell some index. and unwind the position on the closing option and actually if you look at the data you will see that during the 10 minutes leading to the closing option the price of apple went down by two percent despite its weight being increased in the index so what i want to the point i want to make here is that basically just looking at the quantitative aspect would make you potentially mistread which is exactly what happened for a significant number of people on the case of Apple two months ago.
So that's why, in addition to approaching each and every index rebalancing event with a quantitative analysis and quantitative model, we do add some extra layer of information, fundamental analysis, and also the overcrowding factor that we see on the trend.
00:14:07 [Vincent Weber]
And in the example of Apple, so what aspect did the classical quant analysis miss?
00:14:14 [Grégoire Thomas]
in that particular case on this one i would say it's really the overcrowding factor so maybe just to take a few moments to define what it is if i take a step back and i look at the strategy i told you this strategy became more and more profitable as passive management grew and it became a strategy that people started investing into i would say 20 years ago that's actually when we launched the first fund running those strategies here. And initially, the index rebalancing strategy started on the sell side with the prop trading debt of investment firms running the strategy and then migrated to the buy side with our fund and other funds.
And what happened over the years is that the profitability decrease, or you could call it the alpha decay in a way, that's what usually people call it when you look at quantitative signals. The profitability decreased up to a point, and then you had to basically take into account more and more quantitative factors to fine-tune the position you wanted to take. And what happened in 2020 with Tesla was that this was so big and so significant that many people who were not invested in the trade thought about it and said, well, we should try and do that trade.
and they were newcomers maybe they didn't do a research and back test over 20 years and and the market became overcrowded meaning that there were too many people trying to provide liquidity to the passive managers another way to say and as there were too many people trying to provide liquidity the trade became overcrowded so there was too much liquidity provided by people implementing index balancing and so their flows which was matching the fraud of passive manager was bigger than the flows actually of passive managers. And the trade started going the wrong way. And that's why we developed and we added into our model some estimates of how much the trades are being invested into or how much crowding there is.
And it's really one important takeaway for me and I think for index rebalancers who are there for the long run. The models need to be more and more sophisticated and all the time we need to work a lot on our R&D to make sure that we take into account new factors that actually start having an impact on the strategy itself.
00:16:48 [Vincent Weber]
Right. Interesting. And maybe to change your statement that the opportunity for for alpha like decrease over time i mean you publish a piece where you we i think you wrote that sometimes the extent of index rebalancing impact it's correlate with with volatility indicators of six quick so can you elaborate a bit on on that maybe could have been might it be due that the reduced opportunity set was just due to the low volatility environment over the last 10 years
00:17:30 [Grégoire Thomas]
Basically, yes. You're correct. We published a paper on the potential explaining factors of the performance of different rebalances. And basically, we looked at different factors like the number of constituents that would be added or removed, the impact of the different segments of market capitalization. So again, it may be very technical, but This business is quite technical. It's a business and a body of strategies where we start from index methodologies and rules which have an impact on what is going to change in the future. And so, yes, we did study some different factors that could explain how successful an incoming rebalancing is going to be.
So, with you, we looked at the number of stocks that get added or deleted we looked at the interest rate regime we looked at the volatility environment the volatility regime so indeed the vix and there is some correlation for some of the s&p indices again you have a look at the study because it's much more detailed than what i'm going to tell you but definitely we see that there is a correlation between some volatility regime, higher regime, and additions and deletions into actually the mid-cap or small-cap indices. And that's what is interesting. Maybe another segue on that business.
There are so many things you can look at, but basically, when I said there is some correlation between the volatility, the VIX in the US, and some index rebalancing, I already have to qualify it and say it doesn't work for S&P 500. That's interesting because Actually, the field of index rebalancing is very wide. There are many different indices across the world. There are many indices even in one specific country in the US. You have style indices, you have thematic indices. And so what can be true for one index may be false for another one. So the research we did and we published was on a specific set of indices.
Basically, the naive explanation behind the relationship or the correlation between VIX and some index rebalancing is that as you are in a high volatility regime, you would see some dispersion of prices among small caps or mid caps, which means that if you have more dispersion, you would have small caps becoming bigger, so reaching the mid cap status. And therefore, the more volatility, the more dispersion you would have. So the more candidates you would have, the more candidate stocks you would have. for the next rebalancing of the mid-cap index. Because again, if you take a step back, the rules of the mid-cap index is to have a representative set of mid-cap companies in the US.
So if you have a lot of small caps that would become bigger than some mid-caps, automatically, at the next rebalancing, the index provider is going to get rid of some mid-caps, include some small caps, and for us, it's another opportunity to take some long short positions. But I want to qualify the fact that you would find different expense factors for different indices. And that also, I think, the beauty of that index rebalancing feed is that you always have to be on the lookout for new opportunities. And you have to spend a lot of time doing some R&D, which I find very appealing in the market. what you implemented in the past and made you successful is not something that is a given for the future.
You always need to be on the lookout for new things to invest in, even in industry balancing. And I mentioned indices. I would say there are a lot of new developments that we're looking at within this field.
00:21:30 [Vincent Weber]
Great. Beyond the standard rebalancing, we see companies entering or leaving indices due to M&A, sector change, or other corporate events. How does your team assess and prepare for these different scenarios?
00:21:47 [Grégoire Thomas]
It's part of our DNA, actually. The way we are organized, we are a team of different portfolio managers. We have skills, obviously, and different skills, sorry, I should say. Some of us have a more fundamental background, others have a more quantitative background. And I think that's important in the field of index rebalancing because you could have a purely quantitative approach. Some funds do that. But I would say then you need to spread your risk across a large number of constituents and you would miss out on some opportunities. And you mentioned here the M&A, sector changes, etc. And those by nature are much more concentrated usually. So that's where the fundamental approach also brings a lot of value.
Because when you start having a concentrated position because of some M&A or sector changes or corporate events, well, You have a concentrated position, so you need to really dig deeper into the stocks you're going to invest into. And obviously, the quantitative approach is key. I should not use fundamental. The quantitative approach is key when you start the analysis. But since you're going to end up with a more concentrated position, you need that fundamental overlay. And so that's where our team is organized with those different skill sets to make sure that we can all chip in and challenge ourselves. one of us being more fundamentally driven, will come up with a scenario analysis, a rational, a thesis, and those who are less fundamentally driven will question some of the parameters.
And so at the end of the day, it makes for a more robust, the idea is to be robust in the way we implement our rebalances. Because as I was telling you, there are multiple events happening during the year between 50 to 100, depending on where you put a filter or threshold. And so we want to robustly assess each and every one of those. And that's the way we look at those.
I would say that the trend in terms of M&A deletion has been growing over the recent year, given the change in the interest rate environment given the the political impact of the elections but it's definitely something that is becoming more important in 2024 and i would assume it's going to be more important in 2025 these mnas the listening spin-off but it's not something new it's something that i actually had witnessed during my 20 years of running those strategies in previous market environments So it's not something new and it's something we are ready for because we've had the expertise and have done that across the years.
00:24:57 [Vincent Weber]
Right. Thanks. And so the 2020 pandemic was a particularly challenging time for index strategies. So how did your approach evolve during this period? And what key risk management principles emerged?
00:25:18 [Grégoire Thomas]
2020 was actually, because of the volatility, quite supportive for the strategy. Actually, it even ended with what happened on Theta in 2020 and the addition. So I would say that from the point of view purely of the index rebalancing strategies and the liquidity needs of passive management, the price impact, we had a a good year that was followed by 2021 and 2022, which were actually also excellent years with significant opportunities. I would say what really changed was, and that's what I was describing earlier, what really changed was when you started adding a lot of newcomers into the strategy and when new factors like overcrowding became really significant in the performance of the trade. The way we took lessons from that increase of overcrowding was that we adapted our investment process.
We actually kept improving it, which is actually a theme of any investment process that is successful over 20 years. Usually, when someone is successful over 20 years, what he or she was doing 20 years ago, which was successful in a given market environment, has evolved over the years and is different from what the ERC did 10 years ago or what the ERC is doing right now. And so what we did was to evolve our investment process to include those factors, those overcrowding factors, and to actually make them one of our key factors when we analyze a new position. We have defined a quite refined view. What I want to say is that, by instance, as I was telling you, we have multiple events during the year.
We constantly evolve our analysis of the overcrowding depending on all the indices and the families that we invest into and how we see. a trade being implemented by the rest of the market prior to the effective date and after the effective date. So it is something that became like a feedback loop, if you want, in the way we analyze not only our forecast, but also our post-mortem performance.
00:27:56 [Vincent Weber]
Right. Thank you. So there are times where even the best model will need human intervention. So could you share some examples? you had to override your systematic approach? Of course.
00:28:14 [Grégoire Thomas]
I would say maybe that ties into what I was saying earlier. You could have a purely quantitative approach, and I was touching upon that when I was telling you. And I know during my career, I've seen some of those index rebalancing strategies being implemented. If you take a purely quantitative approach, you could say, well, I know how to forecast. to anticipate even before the index provider announces it. I know how to anticipate what stocks could be added or deleted. And that's one typical index rebalancing technology that exists in the market. You do your quantitative analysis. You come up with maybe hundreds of different positions you would want to take. So they are very diversified.
You would take, therefore, those positions maybe for a month with MS, like two months, three months, six months, even a year before the actual implementation of the rebalancing. And that's the purely quantitative approach, very diversified. You can leverage, as you are diversified, you can take a very significant size. And that's one way to look at it. Very systematic, very quantitative. And you don't really need to do a fundamental analysis because you are one year in advance. So what fundamental analysis can you really do that would hold true one year later? That's the extreme purely quantitative, which is not what we're doing.
we are systematic in our approach but as I was describing a bit earlier the process we are opportunistic and we usually do some forecasting but we also invest once the announcements are done by the index provider or once the trade is actually becoming well known and so our approach is obviously quantitative when we start the analysis But we are opportunistic, which means that afterwards, when we end up with the first quantitative estimate and we start looking at more fundamental drivers of the trade and we start looking at the overcrowding of the market, this modifies our decision and is part of our decision-making process. And we can very well end up not being invested in an index rebalancing.
Or we can end up modifying the sizing of the index position we want to take, or we can weed out and filter out some of the trades that initially were proposed by the quantitative approach to take into account basically factors that are not purely quantitative in nature. And that's really what happens during the year. On some of the index rebalancing, we end up not taking any position. We even can end up taking a reverse position. because we think that for a fundamental reason, it is actually going to be a wrong way trade. And that's really the way our investment process works. We don't have to be invested in each and every one of the indexes.
And actually, I think what is a key part of an investment process is that we will always validate our first quantitative take by the fundamental and overcrowding analysis. to end up with a position which is usually different from the purely quantitative approach. That's really actually one key element of our investment process. We don't have a predefined number of additions or deletions. We are ultimately convinced by the dual approach and each and every position we take and put into our book at the end of the day is a conviction built upon the quantitative and fundamental analysis we run.
00:32:02 [Vincent Weber]
Thank you. Grégoire, before we wrap up, I have a tradition on this show. So what's the one piece of wisdom you would share with someone just starting the journey in quantitative investing?
00:32:15 [Grégoire Thomas]
I think you, I had one which was never share your secret for free, but you've seen that you were talking about the secret tot earlier and I didn't reveal much in way of secret tot. I gave you a hint of what I look at when we invest. But now, a bit more seriously, I would say it's a business that changes a lot. And I told you 20 years ago, the opportunities we're capturing, they were on a fairly reduced number of indices. Your benchmark indices in the US, the S&P, in Europe, your stock 50. And then the industry, I think my business evolved and you started adding more and more industries and the universe of possibilities grew. And what's interesting in the business is that what we're doing today is different from 20 years ago.
And so for me, I think that it's a business where there are always opportunities, new opportunities coming. So be curious. That's a key element, I think, in quantitative trading. Be curious. You need to be on the lookout for new opportunities. And always question yourself. Always question when you spot a new opportunity, well, are you the first one to spot it? And that's great. But make sure you always question yourself. You always check, well, is there really something there or am I missing something, a reason why the trade is not working? And then if you've done something successfully for a couple of years, keep questioning yourself on that successful business you're running.
opportunities that you've identified because it may it will disappear actually it may not it will disappear and there will be new opportunities so always be curious on the lookout for new opportunities and question yourself and i think that for me that's one of actually the most appealing aspect of the job it's always changing and and and i love being curious about it great
00:34:14 [Vincent Weber]
Grégoire, thank you for this masterclass in index arbitrage. And I really enjoy your insight to combining systematic analysis with market intuition. To our listener, whether you're directly involved in arbitrage strategy or managing broader portfolios, understanding this market mechanics is crucial in today's environment. You'll find detailed show notes, including key timestamps and additional resources on our website at resonancecapital.com. I'm Vincent Weber, and you've been listening to Resonanz Spotlight. Until next time, stay tuned and stay curious. All investments are exposed to risk, including the risk of capital loss. The main risks associated with investing in index arbitrage strategies are risk of capital loss, equity risk, risk associated with derivative financial instruments, Risk arising from discretionary management and the arbitrage strategy.
More detail on the risk associated with investing in the strategy can be found in the regulatory document.