A fund to gamble on index reshuffles

Arbitrage sounds complicated, until you realise it often simply means buying an asset and selling it on to profit from short-term price differentials. Imagine you could import cars cheaper from Spain than you could sell them for in Britain: that's arbitrage. But if it's that easy, everyone should be doing it.

Which is one reason we're wary on Aviva Investors' new fund, based on arbitraging 'index rebalancing'. Here's how it works. Take the FTSE 100 index. It has a quarterly reshuffle. Each time a few stocks those whose market value has tumbled get relegated to the mid-cap index. In exchange, a few mid-caps get promoted. Passive funds (exchange-trade funds, index trackers and the like) are obliged to replicate the performance of the index. So every time a few firms get promoted into the top tier, those companies get heavily bought by the growing number of index funds. This "rapid growth in passive investment has also created greater anomalies in the marketplace", say Aviva. "Not only do passive investors by their nature allocate capital in proportion to the market capitalisation of existing companies suggesting an inefficient allocation of capital but the rebalancing of indices itself also creates inefficiencies prone to arbitrage."

That's where the Aviva Investors' Index Opportunity Fund (tel: 020-7809 6000) steps in. It looks to buy firms due a promotion to profit from the likely increase in share price following a rebalancing. It also sells those that are likely to be demoted. It repeats this trick for 25 indices across the world.

The fund's performance since launch in April has beaten the FTSE 100, as well as the targeted return of 5% above one-month Euribor (a key interbank interest rate). Aviva's Jerome Nunan tells the FT that cuts by banks and hedge funds mean that the "opportunities thrown up by index rebalancing were less likely to be arbitraged away". In other words, Aviva thinks its competition has dropped away.

So why are we wary? Professional arbitrageurs might be ignoring the strategy now, but that won't last forever, particularly if it works. And the fund isn't cheap: annual fees are around 2% and there's a 10% performance fee on returns above one-month Euribor, which seems a lot to pay for a simple strategy that surely can't sustain its outperformance.