A closer look at index funds

A closer look at index funds
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First Published: Fri, Sep 24 2010. 11 11 PM IST

Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint
Updated: Fri, Sep 24 2010. 11 11 PM IST
On the Economic Consequences of Index-Linked Investing By Jeffrey Wurgler, Stern School of Business, New York University; NBER working paper
Indices have become very important in today’s markets. Stock performance is benchmarked against them, fund managers are evaluated against them and derivative trading on indices forms a very large part of activity on the bourses.
Index funds are a popular way of investing. They have lower expenses than actively managed funds and form an easy way to diversify one’s portfolio. No wonder, then, that trillions of dollars are invested in funds that are in one way or another, linked to indices.
Exchange-traded funds in the US have sprung up like toads in the monsoon, because they give investors an exposure to the allure of emerging markets. But what is the impact of these funds on their underlying stocks and companies? That’s the question Jeffrey Wurgler explores in this paper.
Illustration: Jayachandran/Mint
The most obvious effect is that on a stock that is included in a widely followed index. Index funds will buy stocks that are newly included in the index and sell those that are deleted from the index.
Says Wurgler: “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. Stocks deleted from the index have tumbled by even more.”
But this effect is just the beginning. A stock newly included in the S&P 500 starts behaving very differently from its previous, non-indexed avatar. Wurgler says it’s as if it has joined a new school of fish. There is, he says, increased co-movement with the other stocks of the S&P 500.
Moreover, since indexers and more active investors pursue different strategies, the index stocks tend to move differently from the broader market. Wurgler terms this phenomenon detachment.
Ironically then, indexing may not really deliver what the investor in an index wants: the mimicking of the broader market. Other researchers have claimed to have detected a substantial premium in the performance of the stocks that are part of the S&P 500 index, compared with the rest of the market, over several years.
That may not be surprising, since the frontline stocks have greater liquidity and attract institutional funds.
Wurgler identifies another reason for outperformance. If an index does well, it attracts more funds into it, leading to what he calls a returns- chasing feedback loop. In one word, momentum.
The paper also takes note of strategies that lead to panic selling in index stocks during a crash. Simply put, the author says indexing has increased volatility in the market. He also argues that fund managers benchmarked against an index will tend to favour high-beta stocks, simply because the index is already outperforming for reasons that have nothing to do with the fundamentals. So there’s an incentive to take on higher risk. Wurgler cites research that shows the high returns for benchmark indices have created a problem for active fund managers for decades. That’s because they are measured against the index performance.
Writes Wurgler, “This logic suggests that the popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average, to beat the index—it may actually be contributing to their underperformance. Likewise, if the indexing bubble pops, or even springs a slow leak, even many low-skilled active managers will outperform the benchmark, and the popularity of indexing may wane.”
And finally, companies whose stocks are included or excluded from an index are also affected. The author cites research that finds “new S&P 500 inclusions increase their rate of equity issuance and reduce their leverage”.
To sum up, while the potential benefits of investing through market indices are well known, we need more careful consideration of the ways in which they impact the market.
Write to simplyeconomics@livemint.com
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First Published: Fri, Sep 24 2010. 11 11 PM IST