Blogs & Comment

The broader impact of index investing

A review paper by Jeffrey Wurgler, a professor at NYU Stern School of Business, acknowledges that index investing has been a godsend for investors. But at the same time, he says, index investing is having a broader impact thatisundesirable in several respects.
He touches on the well known index inclusion effect, and cites a study that found additions to the S&P 500 Indexexperienced a price increase of nearly 9%around the event. This extracted a hidden annual cost from the index of 25 basis points, on average.
He also looks at the less well-known, but more important, co-movement and detachment effects. Co-movement is the tendency of index stocks to move together because of highly correlated index-fund inflows and outflows. Detachment is the drift away from the market due, in large part,to the growth of indexing.
Index detachment results in a substantial premium for stocks in the index. A 2001 study cited by Wurgler, for example, estimated a price premium of 40% for S&P 500 stocks. A 2010 study found a smaller, but still noteworthy, annual premium of 82 basis points.
Wurgler also looked at the impact of indexing on corporate financing and portfolio allocation. But another interesting aspectexamined was the impact of indexing on performance evaluation. Let’s briefly look at it.
Index detachment makes it harder to evaluate investment managers, he notes. If the stocks in an index are moving as a separate group, using them as a yardstick to measure a managers skill is problematic. In other words, as indexing becomes more popular and pushesstocks in the index to premiums against non-index stocks, it gives active managers increasingly stiff headwinds to overcome.
The Wurgler paper, therefore, seeks to make a contribution, among other things, to the ongoing debateon the validity of comparing actively managed funds toindexes or exchange-traded funds (ETFs). It is saidthese comparison are misleading because mutual funds include (at least in Canada) the cost of financial advice (trailer fees) but indexes and ETFs do not. Wurgler wouldadd index detachment as a further consideration.
On the Economic Consequences of Index-Linked Investing(2010) by Jeffrey Wurgler