Index-Fund Trillions Are Distorting Prices in the S&P 500

(Bloomberg) - Investors who poured trillions of dollars into index funds because they believed no one could beat the market could actually make it easier to do just that.
All that stupid money could give crafty stock pickers the opportunity to buy smaller businesses cheaply, according to new research.
Scientists have shown that passive flows into the S&P 500 have driven the prices of its largest members disproportionately high over the past two decades - which paved the way for small businesses in the benchmark to ultimately outperform.
To anyone on Wall Street who has witnessed the relentless rise of the megacaps in recent years, this may seem like a wild idea. The argument, however, is that passive currents ultimately make the small members of the S&P 500 too cheap compared to the large ones.
"Inflows into funds that track the S&P 500 index raise the prices of large-cap stocks in the index disproportionately to the prices of the small stocks in the index," wrote authors Hao Jiang, Dimitri Vayanos and Lu Zheng in the newspaper . "The currents predict high future returns for the small-minus-large index portfolio."
The research will prove timely for critics of the passive boom who say a bubble is about to burst in the biggest tech names as small caps embark on fighting form in 2021.
The team from Michigan State University, the London School of Economics, and the University of California Irvine analyzed data from 2000 to 2019.
They found that so-called noise traders tend to raise the price of fashionably big companies as they join the S&P 500. As a result, these companies arrive with higher index weights, which in turn triggers more purchases from capitalization-weighted funds that track the metric.
A similar effect occurs when the funds receive inflows - the new cash is more likely to flow into stocks with high demand from noise dealers.
"When prices are skewed, the weights of the value-weighted indices are biased and the inflows into index funds exacerbate the bias," the researchers wrote.
All of this paves the way for smaller S&P 500 companies to outperform when the price gap eventually normalizes.
Market movements over the past 10 years offer some support for one side of the story. The big companies have gotten bigger, with technology stocks like Apple Inc. and Inc. making up an increasing proportion of the index while smaller companies underperforming global indices.
However, the longevity of this trend has ruined confidence in what is known as size factor, a well-known quantitative strategy based on the notion that small caps outperform large caps in the long run.
The new study suggests that the size effect lives on - only within the S&P 500 and not across the entire stock market, as the old academic studies once noted.
A “small-minus-large” stock portfolio in the index that takes a long position in the smallest stocks and shorts the largest, earns an average of 10% per year. However, an equivalent portfolio of stocks outside of the S&P 500 delivers insignificant returns, suggesting that the mountain of cash indexed to the benchmark may be distorting.
Index fears
Wall Street has long feared the side effects of the indexing boom. Researchers warn above all, from the joint movement of stocks to the threat to standards of corporate governance. About $ 11 trillion in fixed assets is either tied to the S&P 500 or linked to benchmarking
The biggest question that arises with the latest research is whether and how smaller businesses can ever catch up.
Megacap's defenders point to basic justifications for its high ratings, such as big tech's ability to capitalize on technological change and increase profits. There is evidence that passive investment has made the prices of the S&P 500 more informative overall, if not always on an individual basis.
However, if the distortions continue to increase, they can sow the seeds of their own reversal. A working paper of the Supreme Council of the Federal Reserve System last year suggested that ultimately a "feedback" effect could self-disrupt the transition from active to passive.
"As index-driven price distortions become more prominent over time, they can increase the profitability of active investment strategies that exploit those distortions and ultimately slow the transition to passive investing," the authors write.
(Updates with estimate of the S&P 500 Index Cash Trackng.)
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