June 25, 2015 / 5:19 AM / 2 years ago

Banks slash payments to index funds for Russell rebalance

The BlackRock logo is seen outside of its offices in New York January 18, 2012.Shannon Stapleton

NEW YORK (Reuters) - With the annual rebalance of the Russell stock indexes just a day away, brokerage firms are shaving the discounts they typically offer to big index funds on what is usually one of the biggest trading days of the year.

On Friday, Russell will announce the names of some 128 companies that it is adding to its widely-followed Russell 2000 index of small companies. And that’s when the big index fund providers – including Vanguard Group, Dimensional Fund Advisors and BlackRock Inc (BLK.N) - must adjust their portfolios by buying the new stocks and selling the old.

As recently as three years ago, big brokerages such as Bank of America Merrill Lynch (BAC.N) and Goldman Sachs (GS.N) would vie for those orders, confident that they could hand the big fund companies discounts of around .05 percent off of market-priced trades and still make money, mainly by stockpiling the right stocks in advance of the big trade.

But in recent years, that has become harder to do. With FTSE Russell disclosing probable additions and deletions in advance, as well as increased competition from other institutional and retail investors, brokers have not found reconstitution day delivering the easy money it once did.

Now, most brokers are offering the index funds closer to .01 percent to .02 percent, current and former executives at brokerage firms and index fund providers told Reuters. All of the executives wished to remain anonymous because they are not permitted to speak to the media.

"The brokers are finding it is not as lucrative as it once was," said one index fund manager.

There is big money involved. Roughly $835 billion is invested in index funds that track the Russell indices, Russell said. More than $50 billion is expected to change hands in the final moments of Friday, according to New York-based Investment Technology Group.

For example, at BlackRock alone, $41.9 billion in funds track the Russell 2000 index. With about 10.7 percent of those indexes expected to turn over, brokers would pay between $450,000 and $900,000 for the privilege of doing those rebalancing trades - and more to trade for the BlackRock institutional portfolios that also track those indexes. In the era of 0.05 percent discounts, brokers might have paid $2.2 million or more to BlackRock to handle the same volume

Brokerage firms typically start buying shares of the companies that will be added to the Russell indices earlier in the year in anticipation of being able to sell them at a profit on the rebalance day. That was a more lucrative strategy when it was harder to figure out which companies would be added.

Trading off the rebalance months ahead of time is so popular that Charles Schwab Corp has even promoted the strategy to its retail investors.

"If you're a short-term trader, you might want to take advantage of the Russell reconstitution by buying some of the possible additions around the end of March and selling them near the end of June," Schwab wrote in a March 2014 paper promoting its equity rating service.

A Schwab spokeswoman declined to comment.

As a result, these shares are popping months before the reconstitution and then losing ground on the big day.

For example, Reuters analyzed the price performance of the 10 companies that saw the biggest volume boost on the day of the 2014 rebalance. Those shares rose 8.3 percent in the three months leading up to the rebalance, while the Russell 2000 Index rose 2.2 percent.

On the day of the rebalance, they fell 3.9 percent, while the Russell 2000 rose 0.7 percent. They slipped another 10.3 percent in the subsequent three months, while the broader index lost 5.9 percent.

FTSE Russell has made several changes to its methodology over the past several years and made the process more transparent to reduce the volatility in these stocks on the day of the rebalance, said Rolf Agather, managing director, research and innovation indexes at FTSE Russell.

Goldman Sachs, BlackRock, Vanguard and Dimensional Fund Advisors declined to comment. Calls to Bank of America were not returned.

A CROWDED TRADE

Another reason brokers connected to big banks are less likely to offer the aggressive price improvements they once did is the new post-financial crisis regulations requiring banks to keep more capital on hand, executives said.

"A lot of firms are reluctant to put their balance sheet out these days," said one of the brokerage executives, explaining that by buying up the positions in anticipation of the rebalance, they are essentially increasing the amount of risk on their books.

For brokerages, the desire to win the index fund business while managing risk puts them in a difficult spot. On one hand, they want to offer competitive pricing, but on the other, they need to manage their own risk.

"Firms understand this business is a loss leader but the hope is the relationship grows and the broker does other business with those managers," said Peter Kenny, chief market strategist at Clearpool Group in New York.

For example, large index funds can pass on brokerages business from their institutional clients, which is highly lucrative, said one of the executives who works at a large Wall Street bank.

That makes it difficult for firms to stop offering these discounts altogether.

"The index funds have a lot of power right now," said one former brokerage executive.

Reporting by Jessica Toonkel.; Additional reporting by Chuck Mikolajczak, David Gaffen and Rodrigo Campos; editing by Linda Stern and John Pickering

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