The market needs stock-pickers out there actually buying based on estimated fair values – because index investing is grounded on the theory that markets are efficient because there are investors out there doing proper investment analysis. You can’t have everyone just riding along on everyone else’s coattails without anyone actually doing any analysis!
…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 $8,000 billion in countable products.
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 illustrates the phenomenon. It is worth repeating that this pattern is occurring in some of the largest and most liquid stocks in the world.
This “detachment” means that S&P 500 Index members maybe overvalued by the order of 40%. The evidence confirms that stock prices are increasingly a function not just of fundamentals but also of the happenstance of index membership.
This is imperiling us by making bubbles and stock market crashes more likely. ”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.”
The increasing prevalence of index investing also confuses the relationship between risk and return. The basic proposition of asset pricing theory is the positive relationship between risk and expected return, but in this is now incorrect in she stock markets. This 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.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.
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.
Keep in mind that at some point everyone can’t be index-investing, else nobody will be left actually analyzing stocks for their values. While stocks all fell in unison during the crisis, and have seemed to move in lock-step based on macro concerns lately, that doesn’t mean this will always be the case.