Over the last thirty years, the strategy of indexing has rapidly been adopted. Indexing is appealing to investors because they can achieve the return of an index while having low fees. Various studies have shown the advantages of low cost indexing. However, there is a certain myth around indexing that should be addressed. Indexing is widely considered to be a passive investing strategy but I would rebut this belief. Passive investing is not just about reduced activity, low fees and tax efficiency. A stock picker who picks one stock and buys and holds it can be just as inactive as someone who buys one index and holds it. In reality, they’re likely to be more fee efficient than the indexer because there is no recurring cost to holding stock. An index like the S&P 500, however, is an actively selected basket of companies that represent a slice of outstanding global stocks. Because nearly every index is a small piece of all equities, it is actively managed and adjusted. This calls into question whether indexing is actually a passive strategy.
There has been extensive research into market efficiency and the efficient market hypothesis. Perhaps the most well known paper was published by Paul Samuelson and Eugene Fama in the 1960’s. A market commonly is described as efficient when prices fully reflect all available information. There are two pieces that make up market efficiency. 1) Informational efficiency 2) Fundamental value efficiency. Informational efficiency represents how quickly prices respond to new information. Informational efficiency, alone, does not imply that market prices respond to new information correctly or even that prices respond at all. This brings us to fundamental value efficiency. Markets are efficient in the fundamental value sense if prices respond to new information not only quickly but accurately. Both pieces of market efficiency operate independently and both must be present for market efficiency.
It is important to weigh the type of information that is being priced into a security. What happens when new information becomes available but investors must invest substantial time, trouble, or money to get it? What happens when the information is technical and difficult to understand? Do prices still change quickly? In short, the answer is “no.” Certain types of information seem to be absorbed into prices far more slowly and incompletely than the efficient market believers suggest. A phenomenon that has been studied over the last 30 years is “post-earnings-announcement-drift.” An unexpected announcement of increased corporate earnings tends to be followed by atypical positive returns over the next several months, while firms that announce unexpectedly poor earnings see atypical negative returns over an extended period. This is evidence that the initial price response to the new earnings information is unfinished, and that the full implications of the new earnings information are priced in by the market far more slowly than previously assumed.
A recent paper, Konchitchki, Lou, Sadka & Sadka (2013) studied the explanation of the post-earnings-announcement-drift. Among their findings is that investors tend to underreact to new information in earnings. It often will take investors a period of time to incorporate the current earnings into future expectations which causes a drift. The complexity of the information can also impact the drift. This research is indicative that markets are not always efficient.
Indexing and Momentum Investing
Indexing has become more popular with the objective of replicating a particular market index. Using this investment approach, money is allocated by the proportion that a particular stock represents of the index. As such these investors pay no attention to information about a company (other than its market capitalization), much less whether it is fairly priced. Investors utilizing indexing strategies allocate capital using mostly investor flows or index changes instead of new relevant information. An increase in indexing and the consequent decrease in investors making decisions based on the fair value of stocks has the potential to make markets inefficient.
The U.S equity market grew from $11 trillion in 2002 to over $30 trillion in 2014. In that same period, the value of passive funds went from $710 billion to over $7 trillion. As a percentage of the equity market, passive ownership went from 6.50% in 2002 to 24.34% in 2014. The growth in the trend of investing while ignoring new information and valuations is worth noting. Today we have a market where trillions of dollars have been invested by uniformed market participants leading to inefficient markets. A significant proportion of investment funds have been moved into “the market portfolio” in that they are invested on the basis of the proportion that a particular stock represents of the index with no reference to valuation. As such, opportunities are being created for investors who use all available information in their investment analysis.
Momentum investing is another strategy that has grown in popularity. It has been exhibited that momentum investing consistently generates excess returns suggesting a market inefficiency. Momentum comes in different forms with it being measured using past price movements, past returns, or changes in earnings. In most markets, momentum investing plays a role in the management of upwards of 50% of the actively managed funds. Momentum investors represent another large proportion of the market that is in the hands of investors who make no reference to valuation when making their investment decisions. Therefore, they play no role in correcting any market mispricings. An argument could be made that momentum strategies destabilize the infrastructure of the market because they exacerbate existing trends. When investors are attentive to investing in trends and using momentum, they frequently drive the price beyond fair value until the demand from the fundamental investors causes a mean reversion in prices. These mean reversions differ in size and can cause investors to become fearful.
Some researchers believe that indexing can become self-defeating as more and more people adopt it. As the percentage of indexers grows, the markets become more inefficient as the number of investors who perform fundamental analysis shrinks. If everyone adopted indexing, the markets would likely not move much due to the lack of inflows. If there were to be a decrease in indexing, it is likely that equities in the most popular indexes would underperform those that are not in an index.
A self-reinforcing feedback loop has been created by indexing. The performance of indexes has been boosted by indexing which has led to more indexing. However, if this behavior begins to unwind the performances of indexes could suffer compared to the rest of the market.
Markets have demonstrated on multiple occasions in recent years that they are not perfectly efficient. When complex information is introduced to markets, it will often take a period of time to be priced in. Sometimes, it can take a substantial period of time. It is common for investors to underreact to new information which leads to a post-announcement-drift. During this period, investors price in the new information.
People have turned to indexing because they believe it is a good net of all fees strategy. However, not many have thought about the circumstance where indexes underperform the rest of the market. The major indexes like the S&P 500 are often used as a performance benchmark. What happens if the major indexes begin to underperform? Will investors adjust or will they just assume they are still performing with “the market” benchmark? Trillions of dollars have been invested into various indexes while ignoring new information, valuations, growth ect. It is certainly possible that investors who use all relevant information when making investment decisions will favor equities outside of the major indexes due to their discount to those within. This situation would lead to the major indexes underperforming and potentially a reversal of the indexing craze.