When index trackers act as magnifying glasses

When I read a study by Hao Jiang, Dimitri Vayanos, and Lu Zheng on the impact of ETFs and other index funds on stock market distortions I couldn’t believe nobody has ever thought of this effect before. But that’s the hallmark of interesting research. It seems obvious, once you see the results.

The researchers realised that by including stocks in their portfolios according to their market capitalisation, index funds aren’t as neutral about the market as we think they are. In fact, they are actively distorting the market in favour of larger stocks, making the large stocks get bigger while keeping the smaller stocks small.

To see how this works think about the daily gyrations in stock markets. There is a lot of noise in the price of every share. Yet, as of some date, index providers decide, which stocks will be included in an index going forward and which will drop out. Now assume you have two stocks with equal market capitalisation just at the edge of being included in a prominent index like the S&P 500 or the FTSE 100. By chance, on the day the index decides on its cut-off point, the share price of stock A rises while the share price of stock B drops. This leads to the inclusion of stock A in the index while stock B is left out. 

Once the new index constituents go live, ETFs and index funds tracking that index have to buy stock A but not stock B. If the index funds and ETFs get fresh money to invest that wasn’t invested in stocks before, this new money will partially flow into stock A but not in stock B. The result will be a higher share price for stock A and a higher market value for stock A than for stock B. As more and more money flows into index funds, the difference between stock A and stock B becomes bigger and bigger. Index funds act as a magnifying glass for what was initially a random difference between the share price of A and B.

But it gets better. Let’s look at the stocks that are in an index like the S&P 500. There are larger and smaller stocks in that index. Let’s assume stock A and stock B are both in the index and have the same market cap (and thus the same weight in the index). By chance, stock A goes up in price today, while stock B goes down in price. If the index fund receives new money tomorrow, it invests more into stock A than in stock B, creating more demand for stock A than stock B and – everything else being equal – pushing up the price of stock A more than the price of stock B. Again, by investing fresh money, index trackers magnify random small differences in share prices. The result is that over time, the large companies in an index grow faster than the small companies and you get an increasingly concentrated index.

…until, of course, mean reversion kicks in at which point the bloated large stocks have far more downside than they otherwise would have while smaller stocks have far more upside. At that point, small-cap outperformance over large caps becomes more pronounced than without the existence of index funds.