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VIDEOTaking Exception to the Case Against Basket Trading
Is it really accurate to say that indexation and basket trading have destroyed the utility of fundamental analysis by forcing stocks to rise and fall in unison?
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Work with me here.
One of their bugaboos for years has been how indexation and basket trading have destroyed the utility of their fundamental analysis by forcing stocks to rise and fall in unison. Over the short term, this claim is entirely valid; if a stock is a part of a major index-linked exchange-traded fund such as the SPY or QQQQ, it will be starring as the baby thrown out with the bathwater.
But over time, value will come to the fore. The short-term effects of indexation are noise; the long-term impact of fundamental analysis is signal. An analyst shouldn't want to be judged on the twists and turns of the modern high-frequency trading market; this is a Loser’s Game. Conversely, if HFT quant jocks (or, more properly, the software program involved) are thinking about anything longer than the next few microseconds, they've taken their eyes off their chosen ball.
Time Keeps On Ticking, Ticking
If prices separate from their index effects over time, how quickly do they do so? If we examine the members of the Russell 3000 Index, itself tradable under the ticker IWV, and look at their one- and five-day, one-, three- and six-month, and one-, three-, five- and ten-year total returns, we find these distributions look very different from one another. This is to be expected.
Now let’s rearrange the information above to the more usable timeframes of five days and one, three, and six months. Anything longer than six months invites problems associated with secular market trends, the annual reconstitution of the Russell indices, and the survivor bias associated with all indices.
The results are indisputable and, I might add, statistically significant. Regardless of whether the mean of period total returns rises or falls over any of these periods, the variance of those returns rises. Cream rises to the top; let’s not talk about what sinks to the bottom.
We can be assured, therefore, if an analyst can add value, rewards will follow. So what if on any given microsecond IBM (IBM) went down with the basket instead of rising as predicted?As an aside, this is why all of the actions to bust trades outside of bounds imposed after May’s flash crash are so off the mark. If some goof’s computer was willing to sell Exelon (EXC) or Accenture (ACN) at a penny, the best way to stop him from doing so in the future is to make him eat that trade. While he's munching on the losses -- perhaps washed down with a nice dry rosé on a late summer afternoon -- he'll have time to think about how to avoid his own stupidity in the future. Discipline of the market, free markets for free men, and all that. If we bail people out of their losses, where is their incentive to avoid them in the future?
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