> they follow different indices and have similar returns. > Please explain how this is possible while still > underperforming what they 'should' be returning.

> they follow different indices and have similar returns. > Please explain how this is possible while still > underperforming what they 'should' be returning. They are both equity indices and equities are highly correlated to each other. The first principal component of global equity returns explains over 50% of the variance. > Are both indices being front-run? Yes! If a stock is getting added (or dropped) from an index, this is typically announced (depending on the index) between 3 days and a month before the date on which the change to the index is made. The index itself is calculated assuming you bought (or sold) precisely at the close on the day of the reconstitution. Index fund managers are incentivized to match the index. They actually do worse personally if they modestly outperform the index and potentially get fired if they underperform. So every index fund manager wants to buy (or sell) the stock entering (or leaving) the index at precisely the same time on the same day. This means you could potentially have as much as a few months trading volume wanting to transact on the same side at precisely the same time. Smart traders take advantage of this by a) Buying (selling short for deletes) the stock over time before the index is reconstituted. b) Selling what they bought and short selling more (or buying) stock to the index funds at the close and c) Covering their shorts (or selling the excess stock bought) over the next few weeks. The fund managers don't care because even though a typical proprietary trading desk makes tons of money doing this, as far as their clients are concerned, they are matching the index. You could move a stock 50% in the rebalance but you wouldn't notice if you were comparing a fund's returns relative to the index. This is fairly obvious if you simply take a look at price charts of stocks entering and leaving indices around index reconstitutions. Academic studies (use google scholar for a few dozen references) estimate that the typical index addition or deletion to the S&P 500 index moves between 2-4% between announcement and reconstitution. This is an underestimate of what actually happens because adds/deletes are predictable and stocks start moving long before the announcements are made. S&P 500 stocks are the most liquid stocks on the planet and the effect is much larger for other indices. The Russell indices are not much more or less gameable than other indices per add or delete but the effects are concentrated since all Russell Index rebalances happen on a single day (fourth Friday in June) which creates massive jumps in PNL for proprietary trading desks right around that time. It's also fairly obvious if you look at the data carefully that in recent years with the increasing popularity of index funds, the indices are understating the potential returns available in the stock market. The market has done "better" than the oft-quoted returns on the indices would have you believe. > But if they reconstitute at different times how is this > possible. Why would the timing of the reconstitution have anything to do with why this is possible or not?