I – Introduction

Flows, liquidity provision and fundamentals 

Candriam Absolute Return Equity Market Neutral has received The Hedge Fund Journal’s UCITS Hedge award for best risk adjusted returns over 3 years ending in December 2023, in the Equity Market Neutral category, while sister fund Candriam Index Arbitrage has received the award over 1, 2, 3, 5, 7 and 10 years, in the Index Arbitrage strategy category.

Candriam has developed a distinctive approach to trading index rebalancing and equity market pairs. It is mainly discretionary but makes extensive use of quantitative tools and analytics that have been enhanced in recent years. It employs statistical and fundamental data but is also fluid and sensitive to technicals and crowding.

Candriam’s Index Arbitrage and Absolute Return Equity Market Neutral, together running circa EUR 800M both trade the same two strategies: index rebalancing and relative value, but with different levels of exposure, leverage and volatility targets. Candriam Index Arbitrage is amongst a group of UCITS, often managed in France, that target cash plus 1% per year, and has accurately calibrated its risk to achieve a return very close to that: making 46% versus 22.2% for a cash benchmark since 2003. Its gross exposure averages 36%, whereas Candriam Absolute Return Equity Market Neutral could run gross exposure seven times higher, around 245%. It aims for about 5-6 times as much return and volatility and has delivered a 4.3% spread over cash since inception in 2016.

For both funds, the strategy exposure over a whole year averages an even split between the relative value and index rebalancing buckets. However, many index rebalancing events occur quarterly and therefore exposure tends to increase around quarter ends. As long/short funds, short proceeds finance longs and most of the assets are invested in money market instruments which yield a return close to €STR (Euro short-term rate), which is over 3.5% in June 2024.

The rise and rise of passives 

The growing market share of passive equity asset management is a structural driver of opportunities for the two main strategies: index rebalancing and equity relative value. Candriam’s data shows that since 2007 passive funds have received progressively larger net inflows. Though active ETFs are in fact a small growing niche, many are simply converting from mutual funds to ETFs, and the majority of ETF assets remain passive. As such, continuing ETF market share growth is also widely used as a proxy for passive index tracking investment management. 

Passive investment management creates shorter term and longer-term market inefficiencies. “The more money pours into the ETF markets, the larger the demand or supply from passive investors when index changes occur. At the effective dates, we act as providers of liquidity to the passive industry, for which we are compensated. Simultaneously, a large passive industry exacerbates the valuation discrepancies between companies. In this performance bucket, we try to take advantage of these medium-term inefficiencies, for example through pair trades,” explains Grégoire Thomas, who joined as Head of Equity Market Neutral in December 2023.

II – Team

Team revamp

The Hedge Fund Journal interviewed Candriam’s previous index arbitrage manager, Emmanuel Terraz, in 2015, and the succession process shows how the corporate culture differs from other firms where departing portfolio managers are asked to throw their belongings into a plastic bag and marched off the premises within minutes by security guards. “Over a year ago, Emmanuel Terraz informed Candriam of his intention to leave the company and move to the next phase of his career. Anxious to leave the funds’ decades’ long clients in competent hands, he spent the following months helping the existing team members – Damien Vergnaud, Sébastien de Gendre and Celia Fseil – to grow in their roles, handing them more responsibility and making sure they had full autonomy on the process to ensure continuity. At the same time, he sought a successor with comparable expertise who had deployed the strategy across varied market conditions. “I joined the team three months ahead of Emmanuel’s departure, which gave us plenty of time to ensure a smooth transition on every aspect of the job,” says Thomas, who started his career on SocGen’s index arbitrage desk in 2002, a few years after Terraz had left, and later worked for Bank of America and Millennium. “We realized that we were on the same wavelength and were mostly in tune on how we perceived the process and the environment for the strategy,” adds Thomas.

Collegial approach

The team of four seasoned fund managers, all based in Paris, have created a new and very collaborative dynamic covering all stages of the portfolio management process. “Decision-making is very collegial. Every team member is aware of the ongoing opportunities and is expected to pitch in. Every week one portfolio manager takes the lead on the operational aspects of running the books: trading, cash management, risk monitoring etc. This leaves significant time for the rest of the team to focus on their R&D projects. This rotating operating structure is ultimately very worthwhile in creating virtuous circles and feedback loops. Every team member has a full view of the positions in the book, which feeds into their research, and which also feeds back into the operational routines,” explains Thomas.

Enhanced fundamental analysis

Sébastien de Gendre joined Candriam in 2016 to support the launch of the equity market neutral product, which combines fundamental and quantitative analysis. “He has developed a significant enhanced fundamental analysis and has witnessed various developments that have taken place over the years at Candriam, which has given him a vantage point at the forefront of innovation at the firm, in particular when it comes to integrating ESG within alternative strategies,” says Thomas.

Adding quantitative tools

Portfolio managers Damien Vergnaud and Celia Fseil have been in the team for nearly two years and have already made their mark with research. The strategy is mainly discretionary, and their mainly quantitative background has brought a fresh perspective. “Index rebalancing trade implementation has increasingly become systematic amongst our competitors, and while we would not become fully quantitative, we have significantly invested in elevating our quant tools to higher standards, leveraging the technical expertise of Damien and Celia. They have primarily worked on the development of new index rebalancing strategies that have significantly contributed to the fund’s performance in the past year,” reveals Thomas.

III – Relative Value Overview

Defining relative value

The equity market neutral strategy trades around 5,000 stocks in North America and Europe, mainly with market caps above EUR 500 million. The approach to defining pairs is enhanced fundamental analysis: “All the positions we take are the result of an approach that blends quantitative and fundamental analysis. Within the relative value bucket for example, stocks that exhibit strong correlation and co-integration are detected quantitatively to make pairs. We then review the list with a fundamental lens. This is done to avoid trading pairs that don’t make sense from other standpoints such as business similarity, market capitalization, geographical segments of revenues etc.,” says Thomas.

A typical example would be trading Swiss-listed Roche against French-listed Sanofi in the pharmaceuticals sector. Trading this pair in both directions (long Roche versus short Sanofi and then vice versa) could have made a return on capital of 6% in November 2021.

The strategy involves some mean reversion and could be loosely characterized as a form of “statistical arbitrage”, but it is different from many other stat arb strategies in several ways: it uses less leverage, has longer holding periods and fewer positions. Some other stat arb strategies have thousands of positions and are mainly trading intraday mean reversion with leverage of 5 or 6 times or more.   

IV – Index Rebalancing Overview

Defining index rebalancing

Index arbitrage mainly exists within multi-strategy funds or proprietary trading houses, but Candriam offers a rare chance to obtain more focused access to it. “Trading this strategy at Candriam, instead of doing it at a large pod shop, gives us many edges. First, it lets us give investors a unique opportunity to gain direct exposure to these specific strategies which are rare enough to be pointed out,” says Thomas.

The strictest textbook or academic definition of “index arbitrage” involves simultaneous arbitrage of valuation discrepancies between index futures or other index baskets and ETFs, or indices/ETFs and their constituents. This strategy is now dominated by market makers, often as part of the ETF arbitrage mechanism, and high frequency traders that may be trading in timeframes of fractions of a second – milliseconds or microseconds.

Candriam’s version of index arbitrage uses the term to describe what are typically multi-day imbalances caused by event driven rebalancing flows. This involves providing liquidity in anticipation of flows around addition to or deletion from indices, and other reconstitution or rebalancing events that change the weighting of index constituents. These could include changing a country between frontier, emerging and developed market status, rules around free floats and various corporate actions. Flows are also very important in a second sense that is explored later: the total volume of capital dedicated to the index rebalancing strategy itself, in the wider market, is also critical in determining the potential returns.

Premiums for holding inventory

There is not always enough capital exposed to relevant stocks to accommodate trading volumes around index events. “Index adjustments can sometimes create tremendous demand with some stocks expected to trade several times their average daily volumes. As an example, the Russell annual reconstitution in June is often the largest liquidity event every year. Therefore, trading the strategy can be seen as a liquidity provision service for which we are compensated according to current market conditions,” explains Thomas. “In periods of high volatility or market uncertainty, the premium earned is usually larger,” he adds.

Indeed, market makers also earn a premium for holding inventory, which should be higher when prices are more volatile because there is more risk of them losing money on some of the inventory. In decades of academic literature, the market maker risk premium is usually modelled as the bid/offer spread, which will often widen out in more volatile conditions.

Ad hoc, ongoing and quarterly rebalancing

On-going rebalancing can occur on any trading day of the year, mostly because of corporate action events such as M&A, de-listings, spin-offs etc. Lists of corporate events can reach over 100 sorts, and dozens of them can be relevant for indices.

The timing of indices reflecting these changes varies: it can be ad hoc, or it may be synchronized with scheduled adjustments. “Some indices may provide replacements or adjustments immediately and create opportunities for us to arbitrage away. Other index providers may choose to delay the changes until the quarterly rebalancings and reflect them along with other company events that may have occurred such as variations in float levels, number of shares, country or sector changes,” explains Thomas. Quarterly rebalances can follow various quarterly intervals. Most indices e.g. FTSE rebalance in March, June, September and December though some e.g. many MSCI benchmarks can use other quarterly intervals such as February, May, August and November.

All changes result in either adds/deletes or increases/reductions in weightings, which may ultimately lead to the index rebalancing strategy trading hedged long or short positions on the stocks. For an addition or increase, Candriam owns the stock and hedges the beta with some sort of short index position. For a delete or decrease, Candriam shorts the stock, and hedges the beta with some sort of long index position. Other types of hedges can include sector futures, or baskets of stocks.

Opportunistic and flexible

The team are flexible and open minded enough to adapt to the changing opportunity set. “We have strong confidence in the strategy’s ability to deliver consistent performance, but we are always trying to understand how the environment in which we operate can affect it in order to innovate accordingly,” says Thomas.

Candriam does not have to trade every index rebalancing event nor every impacted stock. Whether, when and how they put on a trade is influenced by many factors. “The approach is opportunistic, so there is no pre-defined number of adds and deletes we want to trade,” points out Thomas. This is not a systematic strategy, and the playbook can also be varied flexibly, partly in response to anticipated actions by other relevant players and any other factors that could offset or even outweigh the index rebalancing event.

Varying the textbook playbook

The standard textbook thesis is to expect the stock to outperform (underperform) for a period ahead of inclusion (exit), but subsequently underperform (outperform) at some stage when investors realize it may have become overbought (oversold). Candriam provides two examples when trading additions both ways worked like clockwork. The addition of Stellantis to the STOXX 50 in September 2021 could have generated a 4% profit while Tesla joining the S&P 500 in December 2020 might have made as much as 25%.

“Textbook index rebalancing consists of taking a position at the announcement, holding it until implementation date, and taking the reverse position afterwards. However, most sell-side research now provides prediction analysis on tight rules-based indices which allows actors within the arbitrage space to anticipate the move,” points out Thomas, and therefore Candriam can vary the timing of trades. “Our process is not systematic, meaning that we don’t have strict rules on the timing of the position initiation. Each opportunity is assessed individually to account for several factors such as the expected date of the event, the expected gain, stock-specific news etc.,” adds Thomas.

US and non-US opportunities

The US is the largest global equity market, has a higher share of passive investing, and is naturally therefore the largest source of opportunities. “It is true that the passive US market is larger than the European one. When it comes to region or country-specific indices, the US ones offer larger and more numerous opportunities for us,” says Thomas.

But as always, the strategy can be flexible in picking the best risk/reward trades. An important nuance is monitoring the popularity of specific index providers, which might account for a larger share of certain markets. If one index has a larger market share in a specific country, it could be an especially interesting trade. “The percentage of tracking depends on the popularity of the index provider within certain geographic areas. Some of these index providers are for instance more popular in Europe and therefore offer better opportunities for European stocks than the US sub-index constituents,” says Thomas.

And standalone indices exist to track specific themes. “Clean energy for example has been popular with passive investors for a few years and is now creating interesting index events for us to partake in,” says Thomas.

Some of the changes in these new indices can however turn out to be blind alleys: “ESG indices have grown in popularity in very recent years. Some of them are subsets of larger indices and are often reshuffled at the same time as the rest of the indices, so flows may be netted down and ESG-specific stories may be rendered invisible,” points out Thomas.

V – Opportunity Set

Flows from competing index rebalance traders

Thomas is very familiar with the changing profile of the key players in index rebalancing. “I started my career at SocGen in 2002 trading the strategy within its proprietary trading unit. At the time, arbitrage activities like ours were the purview of large banks. In the aftermath of the 2008 financial crisis, new regulations forced most of them to progressively exit such activities. While some banks are still notoriously very active in the field of index rebalancing, the last decade has seen a remarkable shift of activity towards hedge funds and in particular multi-strategy hedge funds which may employ several teams or pods to trade the same strategy.”

Inflows and outflows into the overall index rebalancing space can happen faster than in the past, as multi-strategy funds running hundreds of billions with access to high levels of leverage (at least 10 times according to US regulatory filings) can quickly shift where they want to deploy capital. “Money can be deployed or retracted at a faster pace resulting in shorter arbitrage cycles,” explains Thomas.

The opportunity set can ebb and flow partly with the amount of capital chasing opportunities, and Candriam attempts to monitor the degree of crowding. “Periods of overcrowding when the strategy lost money have been extremely formative as they prompted us to improve our process. One of our areas of focus in the past two years is trying to adapt our implementation of the strategy to its more turbulent phases and come up with a more stable approach in the long run. At the same time, we now try to keep tabs on the level of capital deployed on the strategy. It is no easy feat due to the obvious asymmetry of information, but by combining some quantitative data and qualitative information, we seek to roughly assess whether the trade is more or less crowded,” says Thomas.

Feast and famine in index rebalancing 2020-2022

Index arbitrage can follow a feast and famine cycle almost like some commodity markets. Thomas recalls: “Performance in 2020 and 2021 made it look very easy to earn money. An emblematic example of that was the addition of Tesla to the S&P 500 in December of 2020 – the largest to date – which was a major success for both index arbitrage players as well as the “trade tourists” it attracted. Some news outlets also began to report on the extraordinary profits made by certain hedge fund managers on the strategy. Everyone wanted in. A talent war raged on in the multi-strategy space. New teams were created, often poaching sell-side analysts, while established pods were offered significantly larger mandates to switch firms. The capital involved became way too large for the strategy to keep delivering extraordinary returns,” explains Thomas.

Russell nemesis

“This capacity and overcrowding issue reached its climax in June 2022 during the Russell annual reconstitution, which strongly traded the wrong way and resulted in large losses for all involved arbitrageurs,” recalls Thomas. This prompted an exodus of capital. “The situation incrementally improved as we started hearing of some pods closing and some multi-strats completely leaving the strategy. We returned to a normal environment mid-2023, with a reasonable amount of money deployed with participants who are here in the long term,” argues Thomas.

VI – New Themes

ESG

These funds report under SFDR 6, but nonetheless an ESG controversy filter is applied, and they integrate ESG, continuing the long history of sustainable investing at Candriam. The firm’s first responsible investing fund was launched in 1996, before the ESG acronym became widely used, and Candriam’s dedicated internal ESG research team started in 2005. The firm has been a UNPRI signatory since 2006, is a member of the UNPRI Leaders Group and has an A+ UNPRI rating. It has several academic partnerships and more than 50 collaborative initiatives.

Investors should watch this space for evolution of the two strategies and the ongoing development of Candriam’s ESG policies.

Nasdaq special MAG 7 rebalance

As a result of the AI-driven frenzy, an interesting theme of 2023 was concentration. In July, Nasdaq announced a special, off-cycle rebalancing which aimed at capping the weights of the Magnificent 7 (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla). “The rebalancing was widely reported in the press due to the size of the flows it created. In fact, the adjustments were as substantial as a regular quarterly rebalancing and were a very profitable trade for the fund,” recalls Thomas.

One-way traffic between US and Europe

A new strategy has developed revolving around the growing trend of firms de-listing from Europe and re-listing in the US, prompting exits from European indices (in the UK, Germany, Italy and Ireland) and additions to their American counterparts. “In 2023, there was CNH Industrial, CRH and Linde. This year Flutter transitioned from premium to standard listing on the London Stock Exchange therefore prompting its deletion from the FTSE indices. Similarly, Shell has announced it was considering becoming a primarily US-listed company,” observes Thomas.

Consequently, European markets and index providers are considering changes to tackle this on-going exodus. “For example, the UK FCA launched a large consultation last year to modify their segment structure and simplify the eligibility criteria. If approved, this new measure could mean companies such as Ferguson or CRH might rejoin FTSE indices should they apply for the new eligible segment. This could offer interesting opportunities for our strategy,” expects Thomas.

Revisiting Asia?

The environment constantly evolves and new themes emerge creating new types of opportunities. The index rebalancing strategy could at some stage revisit Asian opportunities that were traded both by Grégoire Thomas and by Candriam: “In the early days of Candriam Index Arbitrage, Asia was briefly one of the traded regions, but it soon became an operational hassle as the team was much smaller back then. Additionally, Asian markets are very diverse and require specific knowledge of each of their particularities. I have a natural inclination to those markets having traded them for 15 years and I was pleasantly surprised to learn that the team was very eager to learn from my experience when I arrived,” says Thomas. Candriam will proceed cautiously in mapping out the opportunity set. “As is always the case with our process, we look at expanding to Asia in the same way we consider all new strategies: we will perform exhaustive back testing of the trade, understand how this new brick of performance fits within the existing strategies, determine the maximum exposure and study its operational feasibility,” says Thomas.