Many commentators claim that the increased popularity of index funds somehow distorts market prices. Their argument premises that indexing reduces the “efficiency” of price discovery. But should increasing use of index funds really concern investors?
The acceptance of index funds for the portfolio strategy of many investors has received much attention in the financial media. Can index funds become so popular that future expected returns could be worse simply due to “blindly” buying and selling the underlying holdings of a commercial index like the S&P 500? The argument is that due to a rigid process used by “too many” investors, sufficient price discovery may not occur so price “inefficiencies” may occur in financial markets. Using data and reasoning, we can examine this claim to show that markets still work, and that investors can rely on market prices for planning portfolios.
MANY BUYERS AND SELLERS
While the popularity of indexing has increased substantially, index fund investors still make up only a modest percentage of investing overall. Data from the Investment Company Institute1 shows that as of December 2017, 35% of total net assets in US mutual funds and ETFs were held by index funds, compared to 15% in December of 2007, an increase well over 100 percent. Nevertheless in 2017 most total fund assets (65%) were still managed by active mutual funds. When the entire securities market is considered, the percentage of index-based mutual funds and ETFs is relatively small even today. As shown in Exhibit 1, domestic index mutual funds and ETFs comprised only 13% of total US stock market capitalization in 2017
All totals may not equal 100% due to rounding. Sourced from the ICI Fact Book
It should be observed that many investors use nominally “passive” index ETF vehicles to engage in conventional “active” trading. For example, while both a value index ETF and growth index ETF may be technically classified as “index” vehicles, yet many investors actively trade monthly, daily and hourly between these funds and other ETF indexes with different objectives based on short-term expectations, needs, circumstances, or for speculation. In fact, several index ETFs regularly rank among the most actively traded securities.
Beyond traditional actively managed mutual fund vehicles there are many other market participants who actively buy and sell individual securities. These include actively managed pension funds, hedge funds, and insurance companies, just to name a few. Security prices reflect the viewpoints of all these participating investors, as well as those of mutual funds and ETFs.
Professors Eugene Fama and Kenneth French rhetorically asked the question in a blog post titled “Q&A: What if Everybody Indexed?” They explained that the informational impact of an increase in indexed assets depends to some extent on which market participants switch to indexing:
“If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.” 2
In US dollars. Source: Dimensional, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Includes 2017 total returns for constituent securities in the S&P 500 Index as of December 31, 2016. Excludes securities that delisted or were acquired during the year. Source: S&P data ©2019 S&P Dow Jones Indices LLC, a division of S&P Global. For illustrative purposes only. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
THE IMPACT OF VOLUME
Trade volume data provides more evidence of how well markets continue to function even while the level of indexing has increased. Exhibit 2 shows that despite an increasing movement toward passive index funds, equity market trading volumes have remained at similar levels over the past 10 years. This indicates that markets globally still function well enough to facilitate large scale price discovery.
In addition to secondary market trading, other paths incorporate new information into market prices. For example, companies themselves can impact their share prices simply by issuing stock and repurchasing shares. In 2018 alone, there were 1,633 initial public offerings, 3,492 seasoned equity offerings, and 4,148 buybacks around the world.3 The derivatives markets also incorporate new information into market prices: the prices of those financial instruments are linked to the prices of underlying equities and bonds. On an average day in 2018, market participants traded over 1.5 million options contracts and $225 billion worth of equity futures.3
HYPOTHESIS IN PRACTICE
Even though historical evidence suggests that increased levels of indexing is unlikely to distort market prices, let’s consider a counterargument: does increased indexing distort available market information and in turn cause prices to become less reliable? In this case, wouldn’t we expect to see stock-picking managers who claim to capture mispricing of securities have more and more success over the years as an increasing proportion of shares are indexed each year?
Equity mutual fund outperformance percentages are shown for the three-year periods ending December 31 of each year, 2004–2018. Each sample includes equity funds available at the beginning of the three-year period. Outperformers are funds with return observations for every month of the three-year period whose cumulative net return over the period exceeded that of their respective Morningstar category index as of the start of the period. US-domiciled non-Dimensional mutual fund data is from Morningstar. Dimensional fund data provided by the fund accountant. Past performance is no guarantee of future results.
Exhibit 3 shows little evidence to support that assertion. If anything, it suggests the opposite. This chart shows the percentage of active managers that both survive and beat their benchmarks over rolling three-year periods. These data show no strong evidence linking the percentage of indexed equity mutual fund assets to the percentage of actively managed funds successfully outperforming the relative benchmark indices.
Lastly, in a world where a large proportion of index funds could bias prices, we should expect to see some evidence across the holdings of mega index funds. That is, there should be increased uniformity in the relative returns for securities held within the same index as inflows drive prices up among stocks (and outflows drive prices down). The S&P 500 is a widely tracked index with over $9.9 trillion USD indexed or benchmarked to the index and with indexed assets comprise approximately $3.4 trillion USD of this total.4 The S&P 500 Index, however, does not evidence this.
Exhibit 4 shows that in 2008, the first year of the global financial crisis, a year of large net outflows with a negative index return of –37.0%, the returns of underlying individual stocks ranged from 39% to –97%. In 2017, a year with very large net inflows and a positive index return of 21.8%, the constituent returns ranged from 133.7% to –50.3%. Moreover, we would expect that stocks with similar weighting within a conventional market cap-weighted indices would share similar returns. Yet in 2017, Amazon and General Electric returned 56.0% and –42.9%, respectively, despite each accounting for approximately 1.5% of the S&P 500 Index.
Upper chart includes 2008 total returns for constituent securities in the S&P 500 Index as of December 31, 2007. Lower chart includes 2017 total returns for constituent securities in the S&P 500 Index as of December 31, 2016. Excludes securities that delisted or were acquired during the year. Source: S&P data ©2019 S&P Dow Jones Indices LLC, a division of S&P Global. For illustrative purposes only. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
Despite the greatly increased popularity of index-based mutual funds and ETFs, empirical data continue to support the academic notion that informational efficiency of markets works. Annual trading volume has not reduced over the years, so that an enormous volume of market transactions still drives price discovery. Active mutual fund managers continue to underperform by as much as they always have, suggesting that increased indexing makes outguessing the market no easier. Prices of individual holdings within major indices don’t move in lockstep with index fund asset flows. Lastly, while naysayers keep suggesting the “hidden danger” of indexing, the reality is that holdings of index funds are still only a small percentage of the total global investable market.
Investors should be confident that public markets function well; willing buyers and sellers still meet and agree upon prices at which they desire to transact. While indexing has been a great financial innovation, it is only one solution in a universe of alternatives. To become more informed about the possible solutions and strategies, contact a CFP® wealth management professional.
- Derivative: A financial instrument whose value is based on an underlying asset or security.
- Options Contract: An options contract is an agreement between two parties to facilitate a potential transaction on an underlying security at a preset price.
- Futures: A financial contract obligating the buyer to purchase an asset or a seller to sell an asset at a predetermined future time and price.
- 3Options, futures, and corporate action data are from Bloomberg LP. Options contact volume is the sum of the 2018 daily average put and call volume of options on the S&P 500 Index, Russell 2000 Index, MSCI EAFE Index, and MSCI Emerging Markets Index. Equity futures volume is equal to total 2018 futures volume traded divided by 252, where annual volume traded is estimated as the sum of monthly volume times month-end contract value for S&P 500 Mini futures, Russell 2000 Mini futures, MSCI EAFE Mini futures, and MSCI Emerging Markets Mini futures. IPO, seasoned equity offering, and share repurchase data are based on Bloomberg corporate actions data and include countries that are eligible for Dimensional investment.
- 4Source: S&P Dow Jones.