Social Security, Index Funds and Free-Riders

Great Debates
1

In the current debate of Social Security, the Administration would like the public to invest in a broadly diversified stock fund. The index funds are widely cited.

The draw of the index fund rest on the notion of an efficient market. Enough smart people are watching public companies so closely that any change in the business or environment will be accurately reflected in the stock price. No amateur can hope to consistently beat the overall market performance so we should simply put cash in the index funds and match the markets’ gains. From this, the index funds are free-riding on the efforts of the people making the markets efficient. Investors do not need to pay close attention to the investments because they are copying the market rather than anticipating and judging it.

Since the last bubble burst, the index funds have become fairly popular. With this popularity and the possible investment of social security funds, could the index funds get so large that the benefits are destroyed? Could enough money flow into funds designed to match the market that the funds themselves drive the market? Can free-riding drive the system?

If this happens, would companies compete harder to be placed in the S&P 500 than they compete in their business? Would Standard & Poors, Dow Jones and Wilshire become the defacto market movers?

2

Irrespective of anything that might happen to Social Security, any market must reach an equilibrium between efficiency and arbitrage. If a market drifts too far toward perfect efficiency, arbitrage opportunities will disappear, leaving no reward for the analysis necessary to keep the market efficient. But then, as soon as the market drifts too far away from efficiency, such opportunities reappear, and arbitrageurs find their efforts rewarded and steer the market back toward efficiency.

This is true of horse race betting odds, or football betting lines, or stocks, or international currencies, or anything else traded among a large group of people. If horse race odds were perfect, why would anybody bother studying the Racing Form or getting up at the crack of dawn to watch horses run workouts? You could just pick horses at random and get the same results. But if nobody read the Form or watched workouts, how could the odds stay perfect?

If SS privatization adds market players who act randomly (possibly they will be required to do so, by restricting investment options to index baskets of stocks or bonds), in the short run arbitrage opportunities will increase. This will motivate other players, who do have a choice, to move money out of index funds and into actively managed portfolios, taking advantage of such arbitrage until the market moves back toward efficiency and equilibirium is restored.

3

I seem to remember reading about something like your ‘free riding’ problem occuring recently on the London Stock Exchange. A big oil company (Shell maybe?) decided to list entirely on the LSE, pushing its market capitalisation on the LSE up massively. This meant that the index trackers had to hold more of it, so they all bought into it, pushing the price up relative to its competitors, even though it was actually performing far worse.

As Freddy says though behavior like this isn’t really a problem. It just encourages more money to flow into managed funds which can take advantage of the inefficiencies, therefore helping to get rid of them.

4

I see what you mean Freddy the Pig. A lack of efficiency should create an arbitrage opportunity that in turn will drive efficiency. I just wonder if indexing (especially forced indexing) creates something a bit outside of free market theory. What happens when capital allocation becomes mechanical rather than judgement based.

It seems to me that the arbitrage opportunities would change if a sufficiently large amount of assets were invested through an indexing vehicle. Currently the arbitrate is buying or selling on early news, analysis or rumors regarding the financial position of companies and industries. Once the information is public, people jump in or out driving the stock price. Ultimately, the arbitrage is not about the knowledge of the company, it is about the knowledge of what your fellow investors are about to do. If the news is good, you can assume the other investors will rather buy than sell. This net desire to buy drives up the share prices until a sufficient number of other investors are induced to sell. This is where the equilibrium is reached.

At some point in index ownership, the arbitrage stops being about this sort of news. I would imagine it would be about what companies are being added and dropped from the indexes. The bulk of investors are not buying based on companies or industries, they are buying an index. When someone finds out that “widget.com” is being added to the S&P 500, there would be a huge arbitrage opportunity to buy the stock. Once the addition is announced, every S&P 500 fund must add the stock because the investments are done in an automatic way. On the flipside, the stock of the company dropped from the index would be sold automatically. With a sufficiently large amount invested in these funds, wouldn’t this information become the stuff or arbitrage? I doubt that makes the markets more efficient.

Maybe this can only happen with aggregate index funds being a huge percentage of the market. It seems that the social security funds could become that large. If 100,000,000 workers each contribute the $1,000 to a handful of approved funds, they will invest $100 billion per year. This set of funds would become one of the largest fund groups in the world in the first year. Over a couple of decades, these funds will have several trillions of dollars in holdings. They have the potential to become a significant portion of the capital markets. If the investment philosophy remains passive, the (publicly available) mechanical rules for investment could become market movers on their own.

5

To be precise, we need to make a distinction between the effects of passive trading in general, and the effects of passive trading tied to particular stock indices such as the S&P 500, the Russell, or the Wilshire.

The latter effect already exists, and has been documented. I don’t have time to look for cites right now, but people have identified upticks in stocks that become part of the S&P 500, and downticks in stocks that drop out, even when no other underlying fundamental has changed. Put another way, given two companies with identical earning prospects, if one is a member of the S&P 500 and one isn’t, the one that is will trade at a slight premium.

This is a slight market inefficiency, but the only way to profit from it is to predict which companies are about to join or be expelled from the S&P 500. Unfortunately that’s almost as difficult, if not more difficult, than predicting which companies are about to experience a change in earning prospects!

It’s conceivable that SS privatization could exacerbate this effect, but it isn’t large, and I doubt that it ever would become large. There are many indices, after all.

My first post above was addressing the effect of passive trading in general. It can take many forms, from buying an index including every stock traded on an exchange to throwing darts at the financial page. And I say, the more people that do it, the more slight and temporary inefficiencies will be created from which active traders can and will profit. But “slight and temporary” are the operative words. I’m a passive trader myself, happily passing up the possibility of slightly greater returns in return for time to post on the SDMB.

Concerning the possibility of SS players becoming too large, this could be a concern. We already have institutional investors such as CALPERS, which controls $166 billion, and the Magellan Fund, which controls $62 billion, and many others. But you’re right that if people are pumping $50 to $100 billion per year into SS funds, with no withdrawals for the first ten or 20 years, that such funds could dwarf even these large players. This must be considered in designing the program, if in fact one supports such a program.