Technology highflier JDS Uniphase Corp. was gyrating even more than usual earlier this summer, and its frantic dance tells something about a nasty little problem that is beginning to affect more and more investors:
After more than 100 years of dealing with stock indexes, Wall Street still can’t revise an index without developing severe indigestion.
It was announced in July that JDS Uniphase would enter the Standard & Poor’s 500-stock index. In the days before the addition, the stock soared 26 percent in two days of trading, then fell 3.4 percent over another two days of trading.
These moves are caused by mutual fund and other portfolio managers seeking to mimic indexes even as other investors are trying to make money by anticipating such moves, and they can be disruptive.
In December, Yahoo! Inc. gained more than 63 percent in the week before it joined the S&P 500. In the following weeks, starting well before the rest of the market turned down, its stock price crumbled more than 50 percent; it still isn’t back to where it was when it joined the index.
Even broader and, to some investors, more disturbing gyrations took place on June 30 when hundreds of stocks were jolted by seemingly innocuous changes in a variety of indexes, including the Russell 2000 and the S&P Barra growth and value indexes. With billions of dollars of shares changing hands on both the New York Stock Exchange and the Nasdaq Stock Market, stocks that often don’t move much in a month dropped 10 percent in a matter of minutes. Some investors felt they had been hit with a sucker punch.
“There seems to be total disregard for the price that people get for their stocks,” worries Wistar Holt, a senior portfolio manager at PaineWebber in St. Louis.
The various market players involved can’t agree on a solution, so the problem is likely to get worse in the months ahead. And while the problem used to be centered mainly on highflying Nasdaq stocks, the June 30 changes tossed about stocks on the staid Big Board as well.
“These things are supposed to be transparent, and the fact that the New York Stock Exchange didn’t give a good explanation challenges a little bit the integrity of the auction market,” says money manager Scott Black, president of Delphi Management in Boston.
Edward Kwalwasser, the Big Board’s executive vice president in charge of regulation, says it is normal to see such sudden price moves when there are big index changes on the close. “We think we have done everything we can do to smooth things out or provide information,” he says, adding, “If at the end of the day you have 3 million shares to buy or sell, it is likely that the stock will be suspended or that the price will move.”
The stocks involved in the late June mess weren’t the usual, volatile suspects. The one whose sudden move troubled Holt, the PaineWebber manager, was Dillard’s Inc., a regional department-store chain. Others: Dime Bancorp, Claire’s Stores Inc. and even McGraw-Hill Cos., parent of Standard & Poor’s. A small aerospace contractor called Teledyne Technologies fell 10 percent in the 10 minutes from 3:59 to 4:09 p.m. Eastern time, when its final price was posted, and it was simply moving to S&P’s small-cap growth index from its value index.
Traders and investors who study these moves say two things are behind the volatility: normal investment activity and a tactic that Wall Street calls “gaming.”
Many mutual funds, especially those that closely track indexes, switch their holdings when indexes change, and they often switch exactly on the close, to get the precise price at which the stock enters the index.
Volatility gets worse when people try to game the expected surges. Hedge-fund managers and traders on some brokerage-firm desks buy stocks they think the mutual funds will be buying and dump those they expect to be dumped.
Sometimes, they overdo it. They may have overbought Teledyne, which could help explain the sudden selling in the 10 minutes before it actually switched indexes.
“If a shift is overanticipated because too many people bid up a stock in anticipation of demand, and if true demand fails to develop, you can see aberrations,” says David Cushing, managing principal of Inference Group, the investment arm of New York electronic institutional brokerage firm ITG Inc., which has been studying such moves.
Nasdaq investors in the past have sometimes complained of excessive volatility, so the Nasdaq Stock Market mobilized for the June 30 changes with 40 extra supervisors and regulators to monitor trading. It warned members “that we were watching closely for what could be seen as violation of rules, potential market manipulation and failure to get best execution for customers,” says Nasdaq senior vice president Bill Broka.
The controversial stock moves that day took place at the New York Stock Exchange. A group of 165 index additions (as well as a few American Stock Exchange stocks) fell an average of 3.1 percent between 3:55 and the 4 p.m. close, according to Cushing’s research. The Nasdaq index additions, by contrast, fell an average of 0.3 percent during the same five minutes.
Almost all of the movement was reversed in the next trading day. But many investors caught in the moves on June 30 paid a price.
Big Board officials say they haven’t any indication that Big Board “specialists,” who make markets on the exchange floor, failed to meet the exchange’s deadlines or provide timely information.
To avoid these last-minute crunches, the Big Board has proposed to carry out index changes at the start of trading, rather than at the close. But index companies say that is impractical.
“When this was first brought up in early 1999, we discussed it with the exchange two or three times and talked to a number of different index funds and large index traders,” says David Blitzer, who is chairman of S&P’s index committee. “Not a single company or organization that we talked to wanted to move it to the open. They were very adamant about that. They saw no improvement. They were worried about getting information and about the amount of liquidity at the open. They felt that the open price would be easier to manipulate.”
Dow Jones & Co., which publishes The Wall Street Journal and also oversees the Dow Jones indexes, has begun announcing news of planned index changes at the open of trading, rather than the close, to avoid sparking overnight trading based on the news. But as for the actual changes themselves, “I don’t think that moving them to the opening is a workable solution,” says John Prestbo, editor of the Dow Jones global indexes. Because stocks open at varying times, changing the index’s composition on the open could create confusion about the index’s value, he says.
Another problem is that the Russell indexes are revised only once a year, at the end of June, which results in hundreds of changes at once, at the end of a quarter. Russell officials note they once did revise the index more frequently, but that clients complained it boosted trading costs.
“We really are not considering any dramatic moves at this point,” says Mark Hansen, a managing director at Frank Russell in Tacoma, Wash.
A more troubling question is whether the New York Stock Exchange specialist system, which requires trades in any stock to be funneled through a single market maker on the exchange floor, can handle the mounting volumes involved when indexes are changed.
Some market participants think the Nasdaq system, with a variety of brokerage-firm market makers, permits the big volumes to be laid off more smoothly. Many on the New York Stock Exchange vehemently disagree.
