III – Relative Value Overview
Defining relative value
The equity market neutral strategy trades around 5,000 stocks in North America and Europe, mainly with market caps above EUR 500 million. The approach to defining pairs is enhanced fundamental analysis: “All the positions we take are the result of an approach that blends quantitative and fundamental analysis. Within the relative value bucket for example, stocks that exhibit strong correlation and co-integration are detected quantitatively to make pairs. We then review the list with a fundamental lens. This is done to avoid trading pairs that don’t make sense from other standpoints such as business similarity, market capitalization, geographical segments of revenues etc.,” says Thomas.
A typical example would be trading Swiss-listed Roche against French-listed Sanofi in the pharmaceuticals sector. Trading this pair in both directions (long Roche versus short Sanofi and then vice versa) could have made a return on capital of 6% in November 2021.
The strategy involves some mean reversion and could be loosely characterized as a form of “statistical arbitrage”, but it is different from many other stat arb strategies in several ways: it uses less leverage, has longer holding periods and fewer positions. Some other stat arb strategies have thousands of positions and are mainly trading intraday mean reversion with leverage of 5 or 6 times or more.
IV – Index Rebalancing Overview
Defining index rebalancing
Index arbitrage mainly exists within multi-strategy funds or proprietary trading houses, but Candriam offers a rare chance to obtain more focused access to it. “Trading this strategy at Candriam, instead of doing it a large pod shop, gives us many edges. First, it lets us give investors a unique opportunity to gain direct exposure to these specific strategies which are rare enough to be pointed out,” says Thomas.
The strictest textbook or academic definition of “index arbitrage” involves simultaneous arbitrage of valuation discrepancies between index futures or other index baskets and ETFs, or indices/ETFs and their constituents. This strategy is now dominated by market makers, often as part of the ETF arbitrage mechanism, and high frequency traders that may be trading in timeframes of fractions of a second – milliseconds or microseconds.
Candriam’s version of index arbitrage uses the term to describe what are typically multi-day imbalances caused by event driven rebalancing flows. This involves providing liquidity in anticipation of flows around addition to or deletion from indices, and other reconstitution or rebalancing events that change the weighting of index constituents. These could include changing a country between frontier, emerging and developed market status, rules around free floats and various corporate actions. Flows are also very important in a second sense that is explored later: the total volume of capital dedicated to the index rebalancing strategy itself, in the wider market, is also critical in determining the potential returns.
Premiums for holding inventory
There is not always enough capital exposed to relevant stocks to accommodate trading volumes around index events. “Index adjustments can sometimes create tremendous demand with some stocks expected to trade several times their average daily volumes. As an example, the Russell annual reconstitution in June is often the largest liquidity event every year. Therefore, trading the strategy can be seen as a liquidity provision service for which we are compensated according to current market conditions,” explains Thomas. “In periods of high volatility or market uncertainty, the premium earned is usually larger,” he adds.
Indeed, market makers also earn a premium for holding inventory, which should be higher when prices are more volatile because there is more risk of them losing money on some of the inventory. In decades of academic literature, the market maker risk premium is usually modelled as the bid/offer spread, which will often widen out in more volatile conditions.
Ad hoc, ongoing and quarterly rebalancing
On-going rebalancing can occur on any trading day of the year, mostly because of corporate action events such as M&A, de-listings, spin-offs etc. Lists of corporate events can reach over 100 sorts, and dozens of them can be relevant for indices.
The timing of indices reflecting these changes varies: it can be ad hoc, or it may be synchronized with scheduled adjustments. “Some indices may provide replacements or adjustments immediately and create opportunities for us to arbitrage away. Other index providers may choose to delay the changes until the quarterly rebalancings and reflect them along with other company events that may have occurred such as variations in float levels, number of shares, country or sector changes,” explains Thomas. Quarterly rebalances can follow various quarterly intervals. Most indices e.g. FTSE rebalance in March, June, September and December though some e.g. many MSCI benchmarks can use other quarterly intervals such as February, May, August and November.
All changes result in either adds/deletes or increases/reductions in weightings, which may ultimately lead to the index rebalancing strategy trading hedged long or short positions on the stocks. For an addition or increase, Candriam owns the stock and hedges the beta with some sort of short index position. For a delete or decrease, Candriam shorts the stock, and hedges the beta with some sort of long index position. Other types of hedges can include sector futures, or baskets of stocks.
Opportunistic and flexible
The team are flexible and open minded enough to adapt to the changing opportunity set. “We have strong confidence in the strategy’s ability to deliver consistent performance, but we are always trying to understand how the environment in which we operate can affect it in order to innovate accordingly,” says Thomas.
Candriam does not have to trade every index rebalancing event nor every impacted stock. Whether, when and how they put on a trade is influenced by many factors. “The approach is opportunistic, so there is no pre-defined number of adds and deletes we want to trade,” points out Thomas. This is not a systematic strategy, and the playbook can also be varied flexibly, partly in response to anticipated actions by other relevant players and any other factors that could offset or even outweigh the index rebalancing event.
Varying the textbook playbook
The standard textbook thesis is to expect the stock to outperform (underperform) for a period ahead of inclusion (exit), but subsequently underperform (outperform) at some stage when investors realize it may have become overbought (oversold). Candriam provides two examples when trading additions both ways worked like clockwork. The addition of Stellantis to the STOXX 50 in September 2021 could have generated a 4% profit while Tesla joining the S&P 500 in December 2020 might have made as much as 25%.
“Textbook index rebalancing consists of taking a position at the announcement, holding it until implementation date, and taking the reverse position afterwards. However, most sell-side research now provides prediction analysis on tight rules-based indices which allows actors within the arbitrage space to anticipate the move,” points out Thomas, and therefore Candriam can vary the timing of trades. “Our process is not systematic, meaning that we don’t have strict rules on the timing of the position initiation. Each opportunity is assessed individually to account for several factors such as the expected date of the event, the expected gain, stock-specific news etc.,” adds Thomas.
US and non-US opportunities
The US is the largest global equity market, has a higher share of passive investing, and is naturally therefore the largest source of opportunities. “It is true that the passive US market is larger than the European one. When it comes to region or country-specific indices, the US ones offer larger and more numerous opportunities for us,” says Thomas.
But as always, the strategy can be flexible in picking the best risk/reward trades. An important nuance is monitoring the popularity of specific index providers, which might account for a larger share of certain markets. If one index has a larger market share in a specific country, it could be an especially interesting trade. “The percentage of tracking depends on the popularity of the index provider within certain geographic areas. Some of these index providers are for instance more popular in Europe and therefore offer better opportunities for European stocks than the US sub-index constituents,” says Thomas.
And standalone indices exist to track specific themes. “Clean energy for example has been popular with passive investors for a few years and is now creating interesting index events for us to partake in,” says Thomas.
Some of the changes in these new indices can however turn out to be blind alleys: “ESG indices have grown in popularity in very recent years. Some of them are subsets of larger indices and are often reshuffled at the same time as the rest of the indices, so flows may be netted down and ESG-specific stories may be rendered invisible,” points out Thomas.
V – Opportunity Set
Flows from competing index rebalance traders
Thomas is very familiar with the changing profile of the key players in index rebalancing. “I started my career at SocGen in 2002 trading the strategy within its proprietary trading unit. At the time, arbitrage activities like ours were the purview of large banks. In the aftermath of the 2008 financial crisis, new regulations forced most of them to progressively exit such activities. While some banks are still notoriously very active in the field of index rebalancing, the last decade has seen a remarkable shift of activity towards hedge funds and in particular multi-strategy hedge funds which may employ several teams or pods to trade the same strategy.”
Inflows and outflows into the overall index rebalancing space can happen faster than in the past, as multi-strategy funds running hundreds of billions with access to high levels of leverage (at least 10 times according to US regulatory filings) can quickly shift where they want to deploy capital. “Money can be deployed or retracted at a faster pace resulting in shorter arbitrage cycles,” explains Thomas.
The opportunity set can ebb and flow partly with the amount of capital chasing opportunities, and Candriam attempts to monitor the degree of crowding. “Periods of overcrowding when the strategy lost money have been extremely formative as they prompted us to improve our process. One of our areas of focus in the past two years is trying to adapt our implementation of the strategy to its more turbulent phases and come up with a more stable approach in the long run. At the same time, we now try to keep tabs on the level of capital deployed on the strategy. It is no easy feat due to the obvious asymmetry of information, but by combining some quantitative data and qualitative information, we seek to roughly assess whether the trade is more or less crowded,” says Thomas.
Feast and famine in index rebalancing 2020-2022
Index arbitrage can follow a feast and famine cycle almost like some commodity markets. Thomas recalls: “Performance in 2020 and 2021 made it look very easy to earn money. An emblematic example of that was the addition of Tesla to the S&P 500 in December of 2020 – the largest to date – which was a major success for both index arbitrage players as well as the “trade tourists” it attracted. Some news outlets also began to report on the extraordinary profits made by certain hedge fund managers on the strategy. Everyone wanted in. A talent war raged on in the multi-strategy space. New teams were created, often poaching sell-side analysts, while established pods were offered significantly larger mandates to switch firms. The capital involved became way too large for the strategy to keep delivering extraordinary returns,” explains Thomas.
Russell nemesis
“This capacity and overcrowding issue reached its climax in June 2022 during the Russell annual reconstitution, which strongly traded the wrong way and resulted in large losses for all involved arbitrageurs,” recalls Thomas. This prompted an exodus of capital. “The situation incrementally improved as we started hearing of some pods closing and some multi-strats completely leaving the strategy. We returned to a normal environment mid-2023, with a reasonable amount of money deployed with participants who are here in the long term,” argues Thomas.
