Index investing supports vibrant capital markets
Index investing has profoundly changed the way investors seek returns, manage risk, and build portfolios.
For nearly 50 years, index investment vehicles have lowered costs and simplified access to diversified investments for all investors, from sophisticated institutions to individuals.
Choice now extends beyond traditional equity indexes, which include stocks in proportion to their market-capitalisation, to a whole array of more dynamic indexes compiled according to other methodologies.
While the benefits of index investing to investors are widely recognised, concerns focus on the role of index investing with respect to efficient capital markets – specifically, that index investing may harm the functioning of equity markets.
However, many of the underlying arguments either are not supported in the data or would benefit from greater clarity and a common language around key concepts.
We see two themes emerging:
First, some commentators have sought to examine the role that index investing plays in capital markets. In particular, they ask whether index funds – index mutual funds and exchange traded funds (ETFs) – have the potential to distort investment flows, create stock price bubbles, or conversely, exacerbate a decline in market prices.
Second, other commentators have explored index investing, stock ownership, and competition, attributing higher consumer prices, escalating executive compensation, and even aspects of wealth inequality to index investment products.
Does index investing distort investment flows into sectors or asset classes?
This theory is based on a concern that index funds drive flows in a potentially disruptive way.
However, it is the asset allocation decisions made by asset owners that drive flows into different asset classes, sectors, and geographies, not the investment vehicles or products.
Drivers of asset allocation decisions include macroeconomic developments such as global interest rate policy.
In addition, index investing overall represents less than 20 per cent of global equities. Index funds and ETFs together represent just over 12 per cent of the US equity universe, and seven per cent of the global equity universe.
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THEORIES |
MARKET REALITIES |
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Flows into index investment are driving up valuations in the stock market, and could create pricing bubbles, or exacerbate downward movements in stocks when sentiment changes. |
It is asset allocation decisions that drive flows into different asset classes, sectors and geographies –not investment styles or products. Index investing is just one way to implement these decisions. If investors favour a particular region or sector they can invest via single stocks, ETFs, managed funds, and derivatives.
In addition, the index universe is extremely diverse across products, vehicles, and providers.
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Index fads drive flows into particular super stocks, inflating prices. |
As above, asset allocations – not products or vehicles – drive flows into different sectors.
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Does index investing hinder price discovery?
This theory asks whether index investing hinders the mechanism by which investors interpret information to determine (or ‘discover’) the price of a stock.
In practice, the efficiency of capital markets has benefitted from leaps in technology. A variety of information sources and market participants contribute to price discovery, and active trading still dominates the process.
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THEORIES |
MARKET REALITIES |
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Index investors cause stock prices to deviate from their correct valuations, by investing on ‘auto-pilot’ – making markets inefficient |
Active stock trading still dominates the price discovery process.
For the price of a stock to deviate from its correct valuation for longer than one trading day, flows and new investments by index funds would need to cause permanent effects on prices.
Any future impact on price discovery by index investing is ultimately self-regulating – resulting in an equilibrium between active and index.
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Index funds are free-riders on the hard work of active managers in determining stock prices, without contributing to efficient markets. |
The trading of ETFs on stock exchanges is an important contributor to price discovery across markets sectors, and individual stocks.
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Index investing is increasing correlation among stock prices, diminishing the ability of active managers to generate returns through stock selection. |
Correlations in returns are driven by factors related to the macro environment –including interest rate levels –not index investing.
The growing market share of index strategies may present opportunities for active managers should we ever get to the stage where index flows affect prices.
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Index investing and price discovery in context
Figure 1 shows the relative size of trading of futures, stocks, and ETFs.
Futures trading volumes far exceed either the secondary market trading in ETFs or the creation and redemptions of ETF shares. Their contribution to price discovery at the sector level is widely acknowledged.
However, while trading in the futures market is largely concentrated in two US indexes – the S&P 500 and the Russell 2000 – ETFs trade more broadly, contributing to price discovery across sectors, countries and asset classes.
Index investing provides a number of important benefits. First, given the diversity of indexes and the breadth of their holdings, index funds provide capital to a very large number of companies across the spectrum of size, geography, and sector.
Second, index investors take a long-term perspective on the companies that they hold. In an era where long-termism is a scarcity, these funds provide stability.
Third, sponsors of large index funds are actively engaged in investment stewardship. The scale of these funds allows firms to invest more resources in this area.
As a result, most large index funds vote their proxies, rather than outsourcing this function to a proxy advisory firm.
Finally, index funds democratise access to diversified investment portfolios. Institutional investors have established diversified portfolios at a low cost for decades.
Index funds allow individual investors to enjoy these same benefits.
Alex Zaika is director of iShares Australia.
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