Excellence

Does the "Index Effect" boost Index Performance?

Excellence

As indexing gains wider acceptance among the investment community, it might affect security prices in the future. This effect is likely to be most acute for large-cap stocks (S&P 500 Index funds) that have attracted most of the index investments in the recent past.

"Indexing has dramatically affected the market. The S&P 500 stocks are selling at a very high historical multiple. One of the reasons is that money is being funneled into S&P 500 Index funds," says Jay Evans, Portfolio Manager of the Galaxy Large Company Index Fund.

There has been a long-standing debate on whether indexing affects securities prices. Conventional wisdom has held that the share of index fund assets is too small to have any consequential effect on prices. George U. Sauter, Managing Director of Vanguard Core Management Group says in his interview that appears in the Spring 1999 edition of "In The Vanguard",

"S&P 500 indexing should have the same impact on all stocks in the index. But the reality is that the largest stocks within the S&P 500 have performed much better than the small stocks in the index, and the largest stocks outside of the S&P 500 have been performing right in line with the same size stocks inside the S&P 500. That just cannot be explained by indexing."

Although index funds account for just 7% of mutual fund assets, their share has been increasing over the past few years. As investors plow money into index funds, there will be more money chasing the stocks that comprise the indexes, that will boost the prices of those stocks, and that will boost the indexes. It's simple demand and supply. "The amount of money put into indexes does influence performance," says Peter di Teresa, stock fund analyst at Morningstar.

"The knock is that index funds are a perpetual investment machine, mindlessly buying the stocks that constitute the index, so as cash rolls in, the index moves higher, without regard for the prices being paid," says Daniel Kadlec in his Time Magazine article, "Stop Bad Mouthing the Index Funds".

S&P 500 Index funds have been the most popular over the years accounting for almost 80% of all indexed assets. There are small-cap index funds too but they have not attracted much attention. The main reason for this has been the superlative performance of large-cap stocks over the years. Some believe that the flow of cash into these funds has likely helped to underwrite the performance of the component stocks.

The benefit of participating in the S&P 500 Index is evidenced by the impact of the share price of Franklin Resources, which was chosen to replace CoreStates in the index following the latter’s merger with First Union Bank. On being added to the index, Franklin’s share price moved up substantially as the index players ploughed into the stock (with the stock price moving in a 52-week range from $25.50 to almost $53).

Most investors erroneously consider indexing to be synonymous with S&P 500 indexing. So when large-cap stocks begin to underperform, so will their index funds. Investors might assume that an indexing strategy no longer works and are likely to desert their S&P 500 Index funds in favor of a more active management style (which also include smaller stocks), bringing large-cap stock prices further down as portfolio managers are forced to liquidate to meet redemptions.

But the poor performance of the S&P 500 Index funds cannot be attributed to indexing. The index funds would underperform because of their large-cap focus, not because of indexing. The fact of the matter is that indexing works in all markets. An indexed portfolio of small-cap stocks will, on average, perform better than an actively managed small-cap portfolio. "I see small and mid-cap indexes doing very well. If I were to make an investment recommendation, it would be S&P SmallCap 600 Index funds," says Mr. Evans of Galaxy Mutual Funds.

The Nasdaq can be considered a "growth index on steroids," with a value loading of -0.5. The R-squareds show how well the returns of each index fit the model, which is very well indeed in almost all cases. The Dow, with only 30 stocks, has the lowest value, but is still quite respectable at 0.87. The alphas tell us how much higher or lower the average monthly return for the index is than is predicted by the model. Most values are very near zero, except for the Nasdaq, which is about 41 bp per month (or 5% per year) higher than predicted by the model.

This laborious preamble is necessary to better understand how real market rotation occurs over decades, because it involves all 3 factors. We'll travel back in time, and plot the returns of $1.00 invested in each of the factors for each decade, starting with the last one:

As you can see, in the 90s the only asset worth owning was the market. The returns of both size and value were negative, which is the same thing as saying that both large cap and growth tilts were favored. No surprise here-large cap growth stocks have been the place to be in recent years.

The 1980s were somewhat different:

Again, "market" had positive returns, but not as dramatic as in the 90s. And unlike the current decade, "value" had significantly positive returns as well. So the growth tilt which did so well would have reduced returns in the 80s.

And finally, the Ghost of Christmas Past, the 70s:

What could be more different than the last decade in the market than an environment where market exposure was a highly negative factor and exposure to small size and value were the only things which saved your bacon? Note particularly the years from 1973 to 1975, where exposure to the value factor nearly made up for the severe market losses of the worst modern bear market.

Finally, consider the Markowitz inputs from 1964 to 1999:

 
Market
Size
Value
Return
SD
Market
1
 
 
5.74%
15.16%
Size
0.26
1
 
2.00%
13.21%
Value
-0.41
-0.24
1
2.96%
12.54

 

The strong negative correlation between market and value is robust, being present in all 3 decades. If anything, it has grown stronger with time. As might be expected, when these values are fed into a mean-variance optimizer a strong value bias appears. In fact, even when one reduces the return of value it does not disappear from the efficient frontier mix until a return of -1.5% per year is reached. In other words, even if the return of the value factor is zero or slightly negative, you still want exposure to it. The "inclusion threshold" for size is almost exactly zero-you have to believe that its return is positive to use it. (Warning: you cannot toss the above parameters into most off-the-shelf optimizers, as the composition constraints are radically different from the standard case, where their sum must equal unity. In the present case all 3 compositions/loadings can add up to any positive or negative number.)

The strong negative correlation between market and value is robust, being present in all 3 decades. If anything, it has grown stronger with time. As might be expected, when these values are fed into a mean-variance optimizer a strong value bias appears. In fact, even when one reduces the return of value it does not disappear from the efficient frontier mix until a return of -1.5% per year is reached. In other words, even if the return of the value factor is zero or slightly negative, you still want exposure to it. The "inclusion threshold" for size is almost exactly zero-you have to believe that its return is positive to use it. (Warning: you cannot toss the above parameters into most off-the-shelf optimizers, as the composition constraints are radically different from the standard case, where their sum must equal unity. In the present case all 3 compositions/loadings can add up to any positive or negative number.)

So over the long haul, the most important "rotation" is in and out of the 3 major market returns factors. And although we can't predict what they will be over the next decade, it's a lead-pipe cinch that they won't look anything like the last 3.

Copyright 2000, William J. Bernstein [/:Author:]