Index Effect

Does the "Index Effect" boost Index Performance?

By Rahul Seksaria, Assistant Editor

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.