Saturday 25 September 2010

Index Investing Becoming a Victim of Its Own Success

Too much of a good thing can end up being bad. That includes using a benchmark index as the basis for an investing apparently.

In the July 2010 paper (download here from SSRN; acknowledgement to Stingy Investor where I found the link) On the Economic Costs of Index-Linked Investing, NYU prof and NBER research associate Jeffrey Wurgler reviews some research results that are disquieting for investors who follow a passive index strategy based on popular indices such as the S&P 500.

Wurgler says: "... the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits ..." The problems:
  • the inclusion of stocks in the index pushes up prices, by around 9% around the time of the event, a factor that has been getting worse as indexing has gained popularity; this effect is observed for other indices besides the S&P 500, like the TSX 300 (now the delicately named TSX Composite, which hides the fact the fact that it has been shrinking steadily in number of stocks over the years to 235 today)
  • active managers who are benchmarked against the index have an incentive to overweight index members, even if they think a non-index stock will appreciate the same percentage, due to lesser tracking error
  • stocks that join a leading index such as the S&P 500 suddenly begin to move much in tandem and keep doing so, which Wurgler vividly likens to the movements of a school of fish; he calls this effect "detachment"
  • the S&P 500 school of fish members moves on their own and less like the overall market, a net loss of diversification for the investor
  • S&P 500 membership has in the past over the long period of 1980 to 2005 conferred an increasing price premium; he cites one study that found the S&P 500 stocks got an 82 basis point annual alpha return premium; while it might seem like a good thing to get a hefty excess return, he says it might be a sign of an "indexing bubble" that will sooner or later deflate
  • as a consequence, bubbles and crashes are more likely; he discusses the mechanism that may explain both the 1987 crash and the May 2010 flash crash
  • the risk and return relationship actually does not hold - low beta(risk) stocks have been found to generate better returns, by a lot, than high beta stocks, a phenomenon he rightly calls a spectacular anomaly; he explains how fund managers benchmarked to an index will favour high beta stocks
  • he raises the possibility that the S&P cap-weighted index amounts to a strategy of large-cap growth and momentum ... "Clearly, the line between passive and active investment is blurrier than usually presented."
Here's another juicy quote: "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."

What does he suggest one do about it?
  • instead of the S&P 500, pick a broader index like the Wilshire 5000 - "The S&P 500 Index's detachment means, however, that it is reflecting less and less the performance of the full stock market. Index funds based on the more comprehensive Wilshire 5000 (which has included as many as 7,200 stocks) are now providing more robust diversification and stock market exposure."
  • exploit the observed "spectacular anomaly" through strategies that focus on low-beta stocks, e.g. employ maximum Sharpe ratio, minimum volatility and absolute returns, though I'd guess that is probably beyond most individual investors' capability
It's the inverse of the dictum that the market only moves towards efficiency if people exploit and thereby remove the inefficiencies - if too many people assume the market is efficient and therefore invest in passive index funds, then the market becomes more inefficient. A delightful irony indeed!


Rob Bennett said...

if too many people assume the market is efficient and therefore invest in passive index funds, then the market becomes more inefficient.

It's true that we need to have people picking stocks for the market to be micro-efficient. But there is an even bigger problem than this with the Efficient Market concept.

We need people to change their stock allocations in response to big price swings to keep the market efficient in a macro sense! It's the heavy promotion of the Buy-and-Hold concept, that it is okay to stay at one stock allocation no matter how insanely overpriced stocks become, that caused the bull market of the late 1990s. And that insane bull market (stocks were overpriced by $12 trillion in January 2000) caused the economic crisis.

Stock prices always return to fair value over 10 years or so (Bogle calls Reversion to the Mean an "Iron Law" of investing). So we knew in 2000 that over the next 10 years we would be seeing $12 trillion of spending power disappear from our economy. Is it any wonder that so many businesses are collapsing and that so many millions are losing their jobs?

A free market economy cannot survive in a world in which Buy-and-Hold is widely promoted. We need to revisit some of our fundamental assumptions re how stock investing works.


CanadianInvestor said...

RB, I think you are right. There is a challenge though - being able to exercise extreme patience, e.g. the 17 years between 1984 and 2001, to allow the mean reversion process to take hold. As the book Yes, You Can Time the Market (my review: points out, following the method can make you lots of money in the very long run.

Rob Bennett said...


I am hopeful about the future.

Once the word gets out to all investors that they need to change their allocations in response to valuation swings, market prices will become self-correcting. If some people sell each time valuations go up, overvaluation becomes a logical impossibility!

In the future, we won't have to wait years to see prices return to reasonable levels. That problem is just a holdover from the days when people believed in the Efficient Market Theory (under which both overvaluation and undervaluation are logical impossibilities). I think it's just a question of our emotions catching up to what our brains took in some years ago.

That's my take, in any event. We'll see.


Richard said...

Indexing would only lose its main selling point if it overwhelmed the market to such a degree that it became easier for active managers to outperform (which hasn't shown up yet but it may take a few years to really get in depth on what's happening now).

Considering that indexing needs to be countered by active fundamental value traders/investors to keep prices in line, the rise of worldwide micro-second arbitrage trading (with leverage), which certainly wasn't happening in the 50s and 60s, is probably helping indexers. Could it be that the market's capacity for indexing investors is increasing? Of course it doesn't follow that it would continue to do so as more investors convert to passive approaches.

Financial innovation has probably strengthened some negative forces though. With momentum traders driving prices away from fundamental value and some passive investors selling on declines and buying on rises there may be a rise in volatility. Dollar-cost averaging probably eliminates a lot of this; you don't care what a trader is doing today when you're building a position over 20+ years!

CanadianInvestor said...

As far as the paper goes we should remember that Wurgler looked specifically at the S&P 500 which has by far the most money attached to it. Indeed, an anti-dote to the bad S&P effects he suggests is to invest in a different broader index.

What he is saying as I understand it is that the S&P500 has had specific mis-pricing (on the stocks within that index) and market-endangering effects. I don't think he's trying to knock all indices or passive index investing in general. The Canadian equivalent where we might expect to see similar problems is the S&P/TSX 60 and index ETFs like XIU and HXT.

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