Investoid

Some traders look for ‘high probability’ trades, based on mathematical assumptions about how stocks behave. Others look for arbitrage opportunities or other systematic deficiencies that can lead to a guaranteed (or nearly guaranteed) profit. One of the opportunities I find that presents a high probability and highly profitable trade is index changes.

Once in awhile, major indices will change the complement of stocks in their basket. Sometimes this is due to some companies going private, other times it is because a company has outgrown an index’s stated target (eg. a small cap index). In yet other instances a company is failing to meet listing requirements or is otherwise being halted from trading. Whatever the reason, when a company is added or dropped to an index it is a good trading opportunity.

Why? Because in today’s passive investing world, there are trillions of dollars dedicated to tracking various indices. This means that when a company is added to an index, index fund managers are obligated to purchase the stock reasonably quickly, or else their fund’s performance will begin to materially deviate from the underlying index. Furthermore, many actively managed funds are closet index funds, meaning they want to ensure they typically purchase the companies in an index to ensure they do not underperform their benchmarks.

This adds up to a lot of buyers chasing a relatively small amount of sellers. The Vanguard S&P 500 Index alone has $175 billion under management. Even if a new company takes up only 1/2000th of that index, that means the fund must purchase $87.5 million worth of stock in a company that probably has a market cap of about $10 billion, which represents nearly 1% of the company’s total shares outstanding. And that’s just for one fund, albeit the biggest. The opposite effect is true for companies that are dropped from indices. The larger the index (and the more followed it is), the greater the effect.

As a result, you typically see a sustained run in a company’s stock for anywhere from a few days to a few weeks. It is especially astute when the announcement occurs prior to the actual change: despite the fact that the stock will jump on the news, the true increase in price will only occur once the change happens and fund managers begin to buy the stock.

One recent example of this phenomena is Expedia (EXPE: Nasdaq). It was announced on Sept 24 that the stock would be added to the S&P 500 on Oct 1. The stock jumped about 5% on the news, but settled around that figure for the next several days. Since Sept 28 (the last trading day before Oct 1), the stock is up another 9.9%.

I played this news by buying a slightly in the money call option. I purchased the Nov $30 call option on Sept 26 for $3.20, and sold it on Oct 2 for $3.90, yielding a 22% gain (not including commissions). While I could have held on for hopes of higher gains (the option is now worth $4.90), but I had hit my target profit and needed to follow my strategy rules.

I have yet to find a specific site or news source that will let me know of upcoming changes to indices, so if anyone out there knows, feel free to leave a comment.

I was approached by Timothy Sykes, a trader who met with success while he was still in high school, to read a pre-release copy of his book, an An American Hedge Fund. I agreed to read it, not sure of what to expect.

After reading through it, I found that the book is an interesting look at Sykes’ life to date. He made the bulk of his money riding penny stocks during the dot com boom, and subsequently continued to increase his wealth during the bust by shorting the same type of companies he rode on the way up. Eventually Sykes decided to leverage his personal funds into creating a hedge fund. While Sykes goes into detail about how he made his millions, this book is not about the method. It is more of a biography that has some interesting thoughts and lessons for active investors/traders.

For me, the most insightful aspect of his book is how he keeps hammering home the mistakes he made and the psychological traits that were behind his trading decisions. I think this is a crucial aspect for anyone to understand in order to achieve long term success in active investing/trading. Sykes’ no holds barred confessionals made me feel like I’ve learned through his mistakes.

Sykes devotes the last part of the book to his trials and tribulations as a hedge fund manager. He becomes disenchanted with the hurdles that hedge funds face when trying to raise capital, and uses this as motivation to write the book. While I enjoyed reading the ending sequence regarding hedge fund regulations, I thought some more detail would be beneficial (although maybe just an egghead like me wants to know the specifics).

Overall, Sykes has written an engaging book that provides some solid lessons about trading psychology. He has a readable style that makes you want to finish the book as soon as possible.

For more info on Sykes’ new pursuit of investor education on the hedge fund industry, check out his website.

Disclosure: I will be receiving a complimentary copy of the book for my review of his work.

The big news on the Canadian financial stock front is that TD Bank (TD: TSX) has agreed to buy Commerce Bancorp, a regional US bank. As the Financial Post article indicates, TD is taking advantage of our historically high dollar to leverage their buying power in the US. Our banks have become relative minnows as financial institutions around the world have consolidated since the early 1990s. The big 5 in Canada have not participated in this wave due to federal regulations restricting mergers within our domestic banks as well as regulations limiting the amount of foreign ownership in Schedule 1 banks.

While Canadian banks have not kept up with global competitors in terms of size, they have exceeded the typical global financial conglomerate in terms of profitability and shareholder return. Since our banks face little competition on the retail banking side, they have been able to milk consumers for high profit margins. Meanwhile, global banks have faced stiff competition around the world as they begin to tread on each other’s turf. As a result, large firms such as Citigroup and Royal Bank of Scotland have underperformed our little banks to a large extent. Overall, our financial sector has outperformed similar US firms over the medium term.

While having Canadian banks eat up smaller US and other global firms may give shareholders and management a good ego boost, I wonder about the long term affect on the bottom line. Most Canadian banks have mixed records of integrating foreign assets into their operations, and rarely have any such assets ever met the same rates of return on capital that domestic operations have. Such acquisitions invariably reduce short term earnings, which may never become accretive. That said, I understand the trepidation that such banks face, seeing how small they have become.

Nonetheless, I am more interested in firms who are looking for higher growth areas than the US. For instance, Scotiabank (BNS: TSX) has a much more emerging market-oriented strategy, which I believe can produce similar rates of return (or at the very least similar absolute earnings growth) to domestic operations.

Make sure you evalute your Canadian financial holdings when they make foreign acquisitions. Depending on the size and scope of the deal, it may materially affect their performance for years to come.