Index Replacement: Pre-Positioning an Inclusion Trade
The index provider announces that Stock B will replace Stock A in a broad large-cap index at the next semi-annual review, effective after 10 trading sessions. Stock B has an estimated free-float market-capitalisation weight of 0.80%; Stock A has 0.60%. You run a proprietary desk that also executes for a passive fund tracking the index. The passive fund has ₹18,000 crore in assets. Stock B's average daily traded value is ₹240 crore; Stock A's is ₹160 crore. On the announcement day, Stock B closes 4.2% higher and Stock A closes 2.8% lower, but both remain liquid. Your desk can borrow Stock B at an annualised fee of 9% and can use single-stock futures, but the futures basis is 1.1% annualised. The fund's tracking-error budget is 10 basis points over the rebalance window. You expect crowding because the announcement is public. The fund's investment mandate prohibits synthetic exposure exceeding 5% of NAV.
1. Estimate the passive buying and selling implied by the fund alone, and assess whether the announcement-day price move is justified by that flow.
Read the worked answer
Fund buying in B = 0.80% × ₹18,000 crore = ₹144 crore. Fund selling in A = 0.60% × ₹18,000 crore = ₹108 crore.
Days of ADV: B = 144/240 = 0.6 day; A = 108/160 = 0.675 day. On the fund's own flow alone, the trade is less than one day of normal volume in each stock. That does not justify a 4.2% jump in B and a 2.8% fall in A. The move is better explained by the much larger passive complex tracking the index and by crowded announcement-day positioning. If total passive assets tracking the index were, say, ₹3 lakh crore, B's flow would be ₹2,400 crore, or about 10 days of ADV, which would justify a larger impact. The dealer should not extrapolate the fund's small flow to the whole market; check total index AUM, borrow availability and futures open interest before treating the move as fair value.
2. How would you implement the fund's switch while respecting tracking error and the synthetic-exposure cap?
Read the worked answer
Use a coordinated basket: sell A and buy B in the index weight ratio, not as two independent orders. Execute through closing auctions and VWAP slices over the 10-session window, starting early enough to reduce tracking error but not so early that the fund bears reversal risk if the index provider changes the decision. The fund can use single-stock futures for B only as a temporary overlay; the cap is 5% × ₹18,000 crore = ₹900 crore, so ₹144 crore is well within the limit. However, the 1.1% annualised futures basis is cheaper than 9% borrow, but futures introduce basis and roll risk. A sensible split is cash purchase for most of B, with a small futures overlay if cash liquidity or borrow tightens. Monitor tracking error daily against the 10 bp budget; if the basket drifts, rebalance with the remaining cash rather than adding leverage.
3. What are the main risks of trading ahead of the rebalance, and how do you control them?
Read the worked answer
The main conduct risk is using the fund's pending order or non-public execution schedule to benefit the proprietary book. The index change itself is public, so proprietary trading on that information is not automatically insider trading, but front-running a client order is prohibited. Control it with a information barrier between the passive fund execution desk and the proprietary desk, no proprietary positioning after the client order is received, and pre-trade approval for any similar stock. Other risks are crowding and reversal: if too many traders pre-buy B, the rebalance-date flow may be smaller than expected and the trade can unwind sharply. There is also liquidity and tracking-error risk if B becomes expensive or A becomes difficult to sell. Use participation caps, avoid concentrated closing-auction orders, and document the execution rationale.