Sal Arnuk and Joseph Saluzzi of Themis Trading recently posted a white paper focusing on the lack of reliability in major market index pricing intra-day. Since dark pools, ECN’s and other alternative trading systems have become so prevalent, the widely followed indexes (DJIA, S&P 500, Russell 2000) are being based on less than 30% of all shares that are actively traded. The implications of calculating index levels with incomplete information seems to raise two questions: 1) Do the market indexes we use an an indicator of market levels, direction and volatility during the day accurately reflect the market’s action? and 2) What are the implications for index-based trading products?
We’ve never been big fans of index-based trading as a stand-alone strategy. It, by definition, exposes portfolios to systemic risk beyond which we are willing to embrace. But for those using ETF”s for portfolio construction, this is an additional risk that should be considered.