Intraday and Night Index Arbitrage (2008)

Introduction The game, a term coined by Beneish and Whaley (1996, 1997, 2002), represents the arbitrage that occurs in response to addition of stocks in the S&P 500 index. (1) It is conducted by both index fund managers and other traders. When changes in an index are announced, index fund managers rebalance their portfolio by buying the added firms. Traditionally, the index fund managers attempted to time the market by jamming the close-buying the stock during the last hour of trading on the day prior to the effective date. More recently, traders attempt to game the index fund managers by getting in the game earlier (on the announcement date) and selling higher to index fund managers on the effective date (Luskin, 2000). Thus, the added stocks may experience price effects at the time of the announcement and around the effective date. The S&P game serves as a unique laboratory to assess arbitrage gains for the following reasons. First, the event (since October 1989) is anticipated fully, as the announcement occurs in advance of the effective date when the index officially is changed. Therefore, it allows some time for arbitrageurs to capitalize on the potential discrepancy in prices, which easily could be done by individual investors. Since 1989, Standard & Poor's has announced the change in the index shortly after the market closes. The effective date commonly is set for five days from the time of the announcement, but has ranged from one day to 20 days. Risk arbitrageurs anticipate that index funds will need to rebalance their portfolios accordingly and take positions in advance of the index funds. While there is strong evidence of gains by risk arbitrageurs, there is limited information about the flow of trading activity in response to the change in the index. Second, because these events have occurred over time, they allow us to test whether time-varying conditions have altered the price adjustment process. Given that arbitrage has been documented in the past, the arbitrage returns in recent years should be reduced as a result of the increased participation by individual investors. Third, the increasing use of after-hours trading over time may have caused a shift in the proportion of the arbitrage returns that occur in that market versus during normal trading hours. In particular, our paper differs from previous research in that we assess the impact of the index changes from a microstructure perspective to address the following questions: * What is the timing of the price adjustment? How long does it take for prices to adjust? Because the announcement occurs after hours, what is the degree of price adjustment in the first after-hours market session versus the subsequent normal day market? Has the proportion of total arbitrage returns that occurs in the after-hours market increased recently in response to the increased trading activity of the night market? If so, this is the first evidence that investors should transact after the close of the day session of the announcement of the change in the S&P Index. * Are arbitrage profits still possible even after considering the actual spread between bid and ask prices? If so, retail investors should operationalize these trading strategies to take advantage of index funds' participation. * What is the proportion of total arbitrage activity that is attributed to institutional versus individual investors? Has this proportion changed over time? If so, retail investors successfully are taking advantage of information technology increasingly available to them in order to generate trading profits. Based on a sample of additions to the S&P 500 index from 1999 to 2002, we are able to address the microstructure-related questions surrounding the arbitrage process. We find that the largest arbitrage profits are earned by investors who enter the game at the beginning of the after-hours session of the announcement date. …