Dow Changes = Arbitrage Opportunity?

Dow Jones announced that Cisco and Travelers will be replacing GM and Citigroup on the Dow as of next week. As of late this morning, the two new components are both up over 4%. Often when a company is added to a major index, it sees a lift in its share price both from the publicity as well as from the need for tracking funds to buy the new components. But is there an arbitrage play to profit even more?

Eliezer Fich, Associate Professor of Finance at Drexel University, believes there is. There are a handful of funds that track or are based on the Dow including the following:

  • iShares Trust DJ US Industrial Sec Index
  • DIAMONDS Trust Series 1
  • ProShares Ultra Dow30
  • ProShares UltraShort Dow30

Dr. Fich says "The replicators, or index trackers, are focused on tracking error, not fund performance. Until the changes in an index become official, the trackers can not change. Arbitrageurs know there is money left on the table and you will begin to see trading abnormality between the tracking funds and the index's individual stocks." Knowing that something is going to happen before it does creates a window where a market inefficiency can be exploited. Traders will look to buy or sell the trackers knowing the value of the Dow itself as next week approaches.

Today, for example, the iShares ETF was up almost twice as much as Dow itself. Fich says "Further, this also opens speculation on the S&P 500. Cisco and Travelers will have more weight on the S&P driving the questions of who will replace GM and how does the larger index change." Interestingly, Fich adds, that with its stake in GM and Citi, the US Government is indirectly helping the hedge funds make money.

Note - arbitrage opportunities often disappear rapidly, once the word gets out and investors act on it.

Comments? Send them to bythenumbers@cnbc.com