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Here’s one for a spirited debate.
A new paper from the National Bureau of Economic Research by Jeffrey Wurgler, Nomura professor of finance at New York University, discusses the potentially overlooked perils of indexing.
The main point is that with ever increasing amounts of money tracking stock indices, stock performance is being skewed based on whether shares sit in an index or not.
Wurgler calls it the “comovement and detachment effect”.
And in Wurgler’s opinion, it could all be having very under- appreciated side effects in equity markets– especially on fundamentals. As he notes:
…these all stem from the finite ability of stock markets to absorb index-shaped demands for stocks. Not unlike the life cycles of some other major financial innovations, the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits while at the same time increasing its broader economic costs.
In Wurlger’s estimates, as much as $8,000bn in countable products.
In terms of the effects, he finds:
On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine percent around the event, with the effect generally growing over time with Index fund assets. 6 Stocks deleted from the Index have tumbled by even more. Given that mechanical indexers must trade 8.7% of shares outstanding in short order, and an even higher percentage in terms of the free float, not to mention the significant buying associated with benchmarked active management"”this price jump is easy to understand and, perhaps, impressively modest.
——
If a one-time inclusion effect of a few percentage points were the end of the story, then the overall impact of indexing on prices would be modest. But the inclusion effect is just the beginning. The return pattern of the newly-included S&P 500 member changes magically and quickly. It begins to move more closely with its 499 new neighbors and less closely with the rest of the market. It is as if it has joined a new school of fish.
Figure 2 (right) illustrates the phenomenon. It is worth repeating that this pattern is occurring in some of the largest and most liquid stocks in the world.7
In essence, he argues that the liquidity and market capitalisation of the stock becomes increasingly irrelevant once it becomes a member of a major index.
And this is where the real economic impact starts, he says, because the motivations of index investors are quite different to those of stock pickers, who do address the fundamentals.
As he explains:
The net flows into index-linked products are both large and not perfectly correlated with other investors' trades. Indexers and index-product users are by definition pursuing different strategies from those of the more active investor. They are less interested in keeping close track of the relative valuations of index and non-index shares. Some are index arbitrageurs or basis traders who care only about price parity between index derivatives and the underlying stock portfolio. The upshot is that over time, the index members can slowly drift away from the rest of the market, a phenomenon I will call "detachment."
Consequently, Wurgler says this detachment may lead to a significant price premium for S&P 500 Index members.
He also cites a paper by Morck and Yang from 2001 which matched stocks within indices as closely as possible to a stock outside the index, with compatability defined in terms of size and industry.
The comparative valuations showed that S&P membership drove up a price premium in the order of 40 per cent.
Which leads him to conclude:
…the evidence is that stock prices are increasingly a function not just of fundamentals but also of the happenstance of index membership. This drives many of the negative consequences noted below.
As for those negative consequences, those are:
1) Bubbles and crashes.
The S&P 500 Index’s visibility and the easy access to ETFs and Index funds facilitate a high sensitivity of flows to returns.
—
Index membership also affects high-frequency risks, and may encourage trading activity that exacerbates those risks. Dramatic examples include the crash of October 19, 1987 and the intraday “flash crash” of May 6, 2010. SEC investigations have centered on S&P 500 derivatives in both cases.
2) A confused risk-return relationship.
Whereas the basic proposition of asset pricing theory is the positive relationship between risk and expected return, he says in stock markets, the proposition is incorrect:
High risk stocks have, on average, delivered lower returns than low risk stocks in both U.S. markets and those around the world.
—-
A $1 investment in a low beta portfolio in 1968 grows to $60.46 by 2008, while the same investment in a high beta portfolio yields $3.77. The high beta portfolio actually has a negative real return; the 2008 portfolio adjusted for inflation is worth 64 cents. Restricting to larger cap stocks doesn't significantly change the qualitative picture.
And this he says is because the basic problem is that managers benchmarked against a simple index will tend to favour high beta stocks – because the index is actually already outperforming versus the fundamentals.
In other words, for a manager benchmarked against the market portfolio, a stock with an alpha of 2% can be a candidate for underweighting. A similar argument shows that such a manager is also incentivized to overweight a low or negative alpha, high beta stock, unless the alpha is extremely negative.
Related links: Stock picks tough as asset paths correlate - FT Can an ETF collapse – FT Alphaville Correlated returns, high-yield edition - FT Alphaville
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