Comment by Veserv
4 days ago
To explain the mechanism simply.
Suppose you had a index of 100 companys each with a market cap of 1 G$ for a total of 100 G$. You have passive investors owning 20 G$ of that index, amounting to 20% of the total, 20% of each company, and 200 M$ per company.
You then rotate out a company for a new one also worth 1 G$. The index is still 100 G$, but to match the index you are contractually required to sell your 20% ownership of the old company and are contractually required to buy 20% ownership of the new company.
However, the newly added company only released 5% of its shares to the public and the founder kept hold of the remaining 95%. Those fund managers are contractually obligated to buy 20% of the newly added company, but only 5% is available. Like a short squeeze, where the squeezer buys and holds supply so there are not enough purchasable shares to cover the shorts (obligated ownership), this is a financial divide by zero.
To get the remaining 15%, which they are contractually obligated to acquire, they must purchase from the founder. As they are in violation of their contract if they fail to acquire the remaining 15%, the founder now has complete control to dictate any price they want.
That is the scheme described: how to short squeeze retirement funds who do not even have shorts for fun and profit.
Note that this is a minor variation on my post on the same underlying topic here: https://news.ycombinator.com/item?id=47392325
This is wrong in multiple ways.
First: 5x5 is 25, not 20. So it's 25% rather than 20%
Second: they only have to buy the 25% of the listed shares.
To take your 1 Trillion example: if SpaceX has a total market cap of 1T, but only 500b get listed on NASDAQ, and the free float is 5%, the index will weigh SpaceX at 25% of the listed shares, which means it will be weighted at 500 * 0.25 = 125b.
And also note that index ETFs have tracking errors all the time (that's why arbitrage traders still have business!), and the ETFs themselves could also track the performance of SpaceX via derivatives instead of buying the stock. And I think, there are many investors of SpaceX who would like to sell some shares. Fund managers won't have an issue finding their phone numbers.
It is amazing that you can complain about a simplified example and then both misunderstand it and get literally every single one of your "corrections" wrong.
1. As I made abundantly clear, 20% is the passive ownership of the index. It has no relation to the index weighting which you are mentioning.
2. They have to buy 20% of the weighted value. The actual weight is 5x the float. I chose to use a weight of 100% instead of a multiple of the float as a simplification since any weighting greater than the float could result in a squeeze given a large enough passive/obligated ownership pool. However, since I was expecting this sort of "correction", I chose 20% passive ownership of the index (i.e. 1/5) so that they would have to buy 20% of the 25% which is 5%, the same amount as the 5% float. This would result in the passive investors having to purchase all of publicly traded stock which is the divide by zero point that spikes the stock. So, even if your correction was not wrong, I also already countered it.
3. Tracking errors are distinct from intentionally not tracking the index you are contractually obligated to match. You are insinuating that the target of these financial manipulations will defend their clients by ignoring their legal obligations and blaming it on "tracking error". While that is possible, I see no reason to assume that will be the case upfront or to do anything other than apply blame to the entity attempting to financially manipulate retirement accounts into lining their own pockets.
4. Yes, there are other insiders with shares. I used a simplified example where there is a single insider, the founder, to highlight the power that the insiders have over the pricing in such a squeeze. However, you also got this wrong because insiders usually have lockup periods after the IPO that are longer than the 15-days expected for index inclusion. As such, the fund managers would not be able to purchase any shares other than the public shares until after the first rebalance.
I don’t think Nasdaq is free float based.
Also, I would be a lot more pessimistic of the index tracking fund managers’ ability or willingness to find extra shares: their goal is to match the index, not beat it. If the index includes the new firm at a blown-up price because everyone sent their buy orders at the same closing auction, then all the index-tracking funds still track their underlying index. They do not care that after that closing auction, the price of the new firm—and likely the index itself—is going to drop.
>I don’t think Nasdaq is free float based.
I recommend the NDX proposal from February which the whole discussion is based upon:
"To balance index integrity and investability, Nasdaq proposes a new approach for including and weighting low-float securities (those below 20% free float). Each low-float security’s weight will be adjusted to five times its free float percentage, capped at 100%. Securities with more than 20% free float will continue to be weighted at full, eligible listed market capitalization, while those below 20% free float will be weighted proportionally to preserve investability."
The document includes a scenario with the rules applied to SpaceX. "Company C" in the table is SpaceX (with some estimated numbers).
https://indexes.nasdaqomx.com/docs/NDX_Consultation-February...
Yes, when SpaceX gets added to the index, it's going to skyrocket for just that reason. The other reason why SpaceX stock is going to skyrocket is because of the "infinite potential". After all, Elon is going to be God-Emperor of Mars, and how much is a piece of that worth?
The OP knows this and wants a window to profit from this squeeze. For the general public index owners, the sooner it's added to the index the better, minimizing the time that traders can front run this squeeze ahead of them.
Perhaps better it's not added to the indices at all, but as long as it's inevitable, the sooner the better.
Being added to the index is literally the only thing causing "the squeeze" according to this description though so how does that benefit either the author or the index holder?
If the stock was added to the index at a normal period then all the shares would be available.
The author wants to buy ahead of the indexes and benefit from the squeeze; he wants the normal rules of waiting a year before SpaceX is eligible to join the indexes to apply.
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How will a colony on Mars be profitable?
How many Earth dollars would you pay to go live on Mars?
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Come on man, either we ship the unmentionables, or the billionaires get to live with their robot love slaves.
Obviously, you don't have enough imagination to keep Musk's ego based cost-proposition elvated.
SpaceX has always been a about convincing private industry to fund the militarization of space.
See https://en.wikipedia.org/wiki/Golden_Dome_(missile_defense_s...
Mars is a thin cover story to get the engineers to feed the War machine. "National security" / nuclear threat is a great excuse to get politicians to sell out the country.
How about we focus on global security?
I thought it was obvious that "God Emporeror of Mars" was a satirical answer. There are a whole bunch of new markets that cheap access to space open up. Like Bezos' dream of in-space manufacturing. Or Musk's dream of data centres in space. Or power gen in space. Or the "cis-lunar economy". Or space tourism. Or He3 on the moon. People will buy SpaceX stock for the potential, even if that potential is pretty much worthless and the chance of SpaceX capturing the gains rather than some other company is fairly low.
"National Security" is just one more in a big list.
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> To get the remaining 15%, which they are contractually obligated to acquire, they must purchase from the founder. As they are in violation of their contract if they fail to acquire the remaining 15%, the founder now has complete control to dictate any price they want.
This is not correct and I'm surprised this comment is upvoted to the top. The float is the float, nobody goes to buy shares that aren't available in the float.
Thanks ++1
> To get the remaining 15%, which they are contractually obligated to acquire, they must purchase from the founder. As they are in violation of their contract if they fail to acquire the remaining 15%, the founder now has complete control to dictate any price they want.
I can't imagine "any price they want" is quite right here. At the very least, shouldn't we expect underwriters and other stakeholders (in this case Nasdaq, Inc.) to negotiate option-contracts as part of the IPO deal to cover their future obligations?
Yes, it might be a "worse" deal than those initial 5% - though we don't even know that - but then institutional investors time horizons are typically much longer than 6 months. Unless you think SpaceX goes straight down to 0, it seems like a risky but calculated, long-term investment.
I agree they could be more transparent about it, but maybe they will send out a notice in the prospectus update?
Index funds have a variety of ways to replicate the index beyond physical replication, including options, buying "similar things", sampling etc..
So yeah, they don't really need to stick to 100% of the presented issue.
Index funds and ETFs also have strict replication rules limiting the amount of non-physical replication in their legally binding prospectus...
The more physical a tracker is, the lower the tracking error, but also the more fees you have to pay. "Good" ETFs/IFs are often 98% physical. This makes for higher fees, but more safety for subscribers in case of large swings.
So it's not like they are _free_ to replicate however they see fit, the replication mechanism is part of the product.
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But the real scenario is going to be different in two ways: Market capitalization of the new company will only be a small fraction of the index total, even after it's been inflated as indicated. And not all investors in companies on the index are index funds, which brings down the number shares needed to align a fund.
Maybe they propose the rule change because it adjusts for some other problematic effect of the existing index rules? The discontinuity might seem acceptable because it is unlikely to be reached according to their simulations.
>That is the scheme described: how to short squeeze retirement funds who do not even have shorts for fun and profit.
How many retirement funds use the nadasq 100 as the benchmark? The only thing that's really objectionable is the 5x multiplier, and so far as I can tell that's confined to the nasdaq 100 index. If the funds use a sane index without such shenanigans, it won't be affected nearly as much, and the whole debate just turns into the perennial question on whether [company] is overvalued and whether passive investors are being taken for a ride.
Most indexes will be affected. Two of the most common indices - the S&P500 and DJIA - are cross-exchange and include Nasdaq stocks. The biggest market cap companies on the market (MAG7) are all on the Nasdaq exchange and comprise about 35% of the S&P.
Is this grey cause it's wrong? They are all on Nasdaq; and also around 35% of S&P. What am I missing? Is it that the "Most indexes" part is wrong (cause there are more than a few thousand ETF)?
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Actually these two indices will not be affected k as the article explains
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Who is contractually obligated to buy?
I have an index fund for NASDAQ with my broker. When I bought into the fund, the broker promised me that with my money, they will buy shares in companies traded on that exchange according to the specific formula that SpaceX is manipulating here. My broker is obligated to buy. They could open a new fund that has a contact like "we'll keep doing what we had been doing except for the whole SpaceX thing" but they would need my permission to move the money. And I'm only in this fund because it was recommended by my 401k provider -- I don't know anything about any of this. That's the messed up thing here -- the people being screwed are not sophisticated investors, it's nurses and school teachers who hope to retire.
Yeah basically this. These shenanigans water down the value of QQQ. The bottom line is if you don't like QQQ, then dont buy it. Buy the stocks separately or a different index. But for people who don't pay attention, or for people whose 401k's limit their investment options, it is difficult / impossible to avoid the shenanigans
If the rules used to compute the index change (as opposed to the index composition of course), are index funds obliged to follow them no matter what? I assume this is very fund dependent, but would be interesting to know what most guarantee.
and that's why sector specific indexes are not "good" - only broad market (heck, even global) indexes are worth passive investing for.
A nasdaq index is no different from any other thematic index (like an oil index, or a robotics index). Thematic indexes tend to fail the investor in the long term for capturing beta. But because of lack of knowledge of the _actual_ academic research by retail investors, a lot of clever marketeers sell the idea of a thematic index as tho it is similar to a broad market index ("safety" and diversification).
Caveat emptor.
Some funds promise to track the Nasdaq. I guess the idea is they can't sorta track it and they can't artificially track it through some financial proxy. They have to own real shares?
Nice explainer here: https://substack.com/@georgenoble/note/c-226667679?r=3il429