How indices affect markets and the real economy
Index-driven mispricings affect expected returns and volatility. They also degrade investors' ability to measure fund manager skill.
Investing in Index Funds. A main selling point for index funds has been comprehensive, low-cost diversification. 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.
Not only are index fund owners experiencing extra risk in the form of low-frequency detachment; index-based trading creates more risk at higher frequency. The reason is that it is a focal point for those who want to change their stock market exposure in a hurry. For an index fund investor, reallocating from a stock market index fund to a bond fund or cash involves two trades, rather than hundreds of individual stock sales. To the extent that investment managers regard index membership as shorthand for liquidity, additional trading pressure may be concentrated on members. "Index trader risk" could be seen as a particular form of noise trader risk; earlier, I discussed two dramatic crashes that may have included this risk.
Index funds can also have interesting expected returns properties that again may confuse rather than simplify portfolio choice. There are several possibilities.
Suppose the cap-weighted index starts with each stock at fundamental value. An i.i.d. mispricing shock would then lead the index fund investor to overweight overvalued stocks. As prices correct over time, this leads to a drag on performance for cap-weighted portfolios, potentially contributing to the observed long-term underperformance of cap-weighted indices relative to equal-weighted indices. Yet if there is an unknown distribution of mispricing in the starting portfolio, as is presumably the case, then we cannot make such a sweeping conclusion.27
A second and very different possibility is that the market tends to underreact to stock-specific news. This does appear to be a stylised fact. In this world, the cap-weighted portfolio's automatic movement toward stocks with positive news shocks induces what might be considered an attractive portfolio tilt; to invest in the cap-weighted index is to pursue something resembling a large-cap momentum strategy.
A third plausible case involves the hypothesised indexing bubble. Figure 3 shows that S&P 500 index members have been on a roll, but if they are overpriced then presumably this cannot last forever. If this is indeed a bubble, then to invest in the cap-weighted index is to pursue a strategy resembling a large-cap growth and momentum strategy, at least before the bubble pops.
For the sake of completeness, I should mention the textbook case: that is, the market is informationally efficient, and therefore indexing by using a subset of the stock universe cannot, on average, be beaten. Unfortunately, the evidence does not support the blanket assumption of market efficiency (I wouldn't write this paper if it did), leaving all the other messy, non-mutually exclusive possibilities.
Clearly, the line between passive and active investment is blurrier than usually presented. In a world of inefficient markets—apparently, our world—to invest in a cap-weighted index is implicitly to assume an investing strategy and take a view on the predictability of stock returns. Ambiguity about what cap-weighted indexing represents complicates the would-be passive investor's portfolio decision.28
The good news is that there are opportunities for the sophisticated investor. Cross-sectional risk-return inversion provides an attractive investment opportunity. Institutional mandates that are flexible enough to capture this include maximum Sharpe ratio, minimum volatility, and absolute returns. The lack of clear benchmarks reduces transparency and accountability, though. Pension and endowment funds would find it more difficult to keep track of aggregate risk exposures.
Performance Evaluation. Finally, index detachment makes it harder to evaluate investment managers. If index members are moving as a separate category, using them as a yardstick to measure a manager's skill is problematic.29 Performance relative to the index becomes period-specific: the likelihood of beating the index depends on which way the detached index members happened to move relative to non-members.