| Does the "Index
Effect" boost Index Performance?
By Rahul Seksaria
1999 |
|
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
