The impact of index-linked investing on the market itself

Trying to parse this article that I found on the question but frankly I could use some help giving it a critical read.

The idea is that so much of the investing market is now investing according to a smallish pool of indices that it impacts the behavior of the market itself. The questionI have is how under different circumstances?


Some excerpts from that essay:

I think index funds promise returns that match the indices, but don’t necessarily promise to fill themselves with the stocks that make up the index. Each index is supposed to be a sort of market indicator and not the best possible selection of stocks, so in principle you could start an index fund that promised to match the index, and invested in stocks better than the index, and pocket the difference. This is what I think index funds actually do.

Thus, it doesn’t have to impact the market in an index-specific way that funds are buying whatever they think they should using other people’s money, and promising those people returns that are pinned to the index.

But I hope somebody who knows more and can confirm or correct comes along.

Nope. An index fund’s advantage is that it is mindless: it automatically invests in the companies that make up the index to the degree of each company’s representative weight in the index in question.

Nope. For the most part, index funds are passively managed - an S&P 500 index fund is comprised of the 500 stocks in the S&P 500. There may be a small amount of leveraging and options taking place, but for the most part, it’s simply matching the index. What you describe is an actively managed fund. Here’s a decent article on the difference.

And the op question remains, informed or not by the linked article - does a larger amount of investments moving as a cohesive mass in and out of a certain 500 stocks (and /or those that make up a few other popular index instrument) change the behavior of the market? The article references that stocks in the S&P are more co-variant, for example, as a result, and discusses certain hypothetical risks that I am not so sure I get. The article spends as much time discussing its impact on the behaviors of active managers working to compare to the indices as their benchmarks and competition as anything else but that is less my curiosity than, say, potential impact on volatility of the S&P and within in (two different things) and what segments of the market may get over or undervalued. Or given the global nature of the markets are the index-linked funds still not so big as to be prime movers in and of themselves?

I think it’s a really interesting question. At what point do the major indices become king makers? And is there an inefficiency that can be found for other funds (passive or active) to take advantage of? I’d love to read more if anyone finds anything.

One criticism I recall was that some funds actually buy “baskets”. If they want telecom, they buy a collection of telecom stocks that make up the index for telecom - with no regard for the thought that some of the companies are turkeys and some good investments. And when the market says “dump” they dump good stocks and bad stocks alike.

Of course. That’s what index funds are supposed to do. The article explains that non-index managers are often effectively forced, e.g. by rating criteria, to behave similarly to index funds. Arbitrageurs are “supposed” to correct for bad pricing due to index inclusion; the article gives reasons that may not work.

The efficient market hypothesis operates on the basis that investors sell bad companies and buy good companies. It won’t operate as effectively if a large portion of investors instead simply sell non-index companies and buy index companies. “Only” $8 trillion is directly invested in index funds, but the article explains why much more money than that is following index-related strategies … and highly-leveraged index derivatives trading further increases the feedback risks.

Apparently the criteria for inclusion on the S&P 500 index are visible and rigid enough that index changes can be predicted. Huge profits are available doing this, according to the article. Is this one strategy of some of the highly successful funds?

Here’s an article from The New Yorker about how passive investing (such as in index funds) might be hurting the market and consumers. One example is of the airline industry, where a small group of institutional shareholders (e.g., Vanguard, Fidelity, Blackrock) own 60-80% of the shares of the big carriers, and that airfares are somewhat higher as a result. (There is a link to an academic paper (PDF warning) that goes into more detail.) Another example is the banking industry.

So is index-linked investment a “bubble machine” as characterized by the Goldman Sachs guy in that article? A bubble is of course only clearly such after it bursts.

Apparently active managers are out there saying it is likely to happen soon. Or are index-linked investors less likely to panic and more inclined to wait a downturn out holding the longterm course?

I’d say that’s likely yet to be defined, but it’s certainly a concern.

I’d also like to offer a slight correction. Not ALL index funds match a specific index. There are sub-index funds - which I am not permitted to mention by name - that match a part of an index. Some match highest dividend payers, or largest cap or whatnot. They’re still passive. They say ‘this is what we’re doing and that’s it’ and call themselves an index fund, but they’re never trying to match the DJIA or the S&P or Russell or whatever.

This is basically correct. Most index funds do not contain every single stock held in the representative index, e.g. Russell 2000 index funds do not contain all 2000 stocks contained in the Russell index. Instead funds usually opt to take a representative sample of the stocks that make up the index thereby avoiding illiquid stocks, but this method carries the risk of tracking error.

Tracking error normally isn’t an issue for large cap indexes but can be significant for microcap indexes since most of the gains in such indexes come from a small number of stocks.

If the risk is that certain index funds are overvalued (say, indexes that track the S&P 500) then doesn’t it make more sense to invest in funds that track the stock market as a whole? It seems like that would be less likely to be overvalued since the effect of passive investors would be more “diluted,” if you will.

Not necessarily. As a trader/investor you don’t care whether a stock or fund is over or undervalued now. You care about whether it’ll become more so over time than other available investments.

IOW, if there’s an S&P 500 “premium” that’s fine. As long as the premium keeps getting bigger, or at least doesn’t shrink, you’ll do better buying the premium fund than you will a fund made of non-premium assets that perform less well.

It’s just another manifestation of the fact that ultimately the market is a social, not an economic, phenomenon. When Apple is going up everybody is buying more Apple. The scary part is as it becomes an ever larger fraction of the S&P index, it becomes ever more important for indexers to buy ever more of it.

So it amounts to a virtuous circle of ever increasing premiums over basic economic analysis. Until some external shock changes it to a vicious one. Then the excitement starts.

Not trying to pick on Apple as such. It’s simply a recent index darling. There have been others going back decades.

As alluded to above, if one could figure out who the S&P numbers 501 to 510 are and predict with reasonable certainty when they’ll be promoted into the magic 500 you could make an outsized reward. Even better if you could trigger those promotions and demotions on cue.

The numbers I’m finding are a few years old, but they indicate that the S&P 500 is about 80% of the value of the market as a whole. So while you can invest in a fund that tracks the stock market as a whole (the Vanguard Total Market Index fund (VTSMX), for instance), you’re close to that with a S&P 500 fund.

Yeah, what you as a trader/investor care/worry about is if it is a bubble. Continually increasing valuations disproportionate to fundamentals make one worry that it won’t keep becoming more so, that it may pop.

Now AAPL may not be the best example in this case. It’s PE (currently 16.4) is quite a bit lower than the average PE for the S&P 500 (24.8) and it pays a reasonable dividend with a yield of 1.67% (slightly less than the average S&P 500 of 2.00%). It has over $246 billion dollars in cash.

Are there members of the S&P 500 that are way overvalued and some that are not? Could a stockpicker earn their keep by picking the ones less likely to pop as badly? Or will the nature of index-linked investment drag down the good along with the overinflated?

Monopoly power increases corporate profits and hence exacerbates income inequality. Inequality is very severe today due to monopoly power (corporate concentration). One of the present-day modes of corporate concentration is closely related to index-linked investing.

Investors: do you root for Pepsi or Coca Cola? Root for Apple or Microsoft? You don’t care – you’re indexed. Even large fund companies without explicit indexing will end up very diversified when their resources are spread across a variety of managers and strategies. Consider this:
[ul][li] The four largest shareholders of JPMorgan Chase are (in alphabetical order) BlackRock, Inc.; Fidelity Investments; State Street Corp.; and the Vanguard Group.[/li][li] The four largest shareholders of Bank of America … are BlackRock, Inc.; Fidelity Investments; State Street Corp.; and the Vanguard Group.[/li][li] The four largest shareholders of Apple … are BlackRock, Inc.; Fidelity Investments; State Street Corp.; and the Vanguard Group.[/li][li] The five largest shareholders of CVS … are BlackRock, Inc.; Fidelity Investments; State Street Corp.; the Vanguard Group; and Wellington Management.[/li][li] The five largest shareholders of Walgreens (CVS’ main rival) are BlackRock, Inc.; Fidelity Investments; State Street Corp.; the Vanguard Group; and Wellington Management.[/li][/ul]
See a pattern here? When BlackRock or Fidelity is voting its shares at a Walgreens stockholders meeting, do you think they’re thrilled with the idea of lowering prices to win business from CVS?

IANA expert. Far from it. My investments have always been better at losing principal than at gaining income/growth. Having said that …

A trader doesn’t much care. He can ride the upside, or if big enough pump the upside, until the inevitable reverse. If he’s real slow (like 2 hours) on the trigger at the top he might give back a couple percent of his overall gains.

Investors are a different matter.

Darn good question. In my decidedly amateur opinion …

If the pop is systemic it’s again a matter of fashion. The relative darling shares will stay relatively overvalued compared to the wallflowers until they don’t. For reasons rational or not.

If the pop starts out specifically with one of the especially overvalued darlings then the index selling pressure will be concentrated on that stock. e.g. Imagine Apple unveils a turkey so bad even the fanboys pan it. If so, it’ll badly underperform the index for awhile as the index funds rebalance that issue downwards to be a much-shrunken percentage of the tracking portfolio. Note this is a positive feedback loop. The more they rebalance away, the more the price falls and the more they need to rebalance away again. That way lies share price free-fall.

But whether that means you can make money in the wallflowers of the index or can merely lose money more slowly is going to depend on the larger-scale situation. I have a hard time imagining the wall flowers or the index itself moving up enough to counteract the FUD while the market is stampeding away from what had seemed like a sure thing hot bet.

For sure the high frequency traders can make a mint on the volatility and volume. The rest of us? Probably not with that tactic.

There are always companies that are overvalued while others are undervalued. Obviously, the trick to successful active investing is identifying which is which. There is, for example, a Dogs of the Dow strategy in which the idea is to invest in those Dow companies whose dividend is the highest fraction of the stock price (the theory is that these blue-chip companies don’t change their dividend frequently, so this indicates that the stock price will rise).

And Warren Buffett has made a little money through value investing. (Note that he’s traditionally avoided technology stocks, saying that he doesn’t understand the business and it’s volatile. But last year, he bought quite a bit of Apple stock.)