The Impact of Index Trackers on Shareholders and Stock Volatility

Executive Summary

• Indexes and index-tracking strategies are an increasingly important feature of the contemporary investment environment.

• Index tracking has become a risk-averse strategy for institutional investors, and its popularity has grown strongly, especially within developed capital markets where it is considered difficult to outperform the market reliably.

• Indexes (and indexed portfolios) are actively managed instruments which are constructed according to objective criteria. Their performance typically depends on the market capitalization (size) of stocks.

• Index membership literally confers “investment grade” on firms because numerous managed funds are benchmarked to, or directly invested in, these stocks. Index membership also increases institutional investor ownership levels, trading liquidity, and research coverage by market analysts.

• Index changes can have dramatic effects on stock prices and trading volumes, especially over the short to medium term; longer-term effects remain unclear.

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Introduction

Stock indexing, where investment portfolios mimic or replicate market indexes, has profound implications for both firms and investors. The practice stems from theoretical research which suggests that markets are informationally efficient. Since security prices generally reflect all public information, there is no point in employing active fund management and paying for investment research if there is no prospect of reliably beating the market. Whether or not you believe that beating the market is achievable—and this remains a perennial debate within academic and practitioner circles—the reality is that institutional investors make portfolio allocations with close reference to market indexes. The essential issue for investors and financial managers, therefore, is to be aware of how indexes are managed and to understand the implications for stocks arising from index tracking.

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What Is the “Market”? A Primer on Indexes

This is a seemingly innocuous question, but one that is seldom asked by investors, financial managers, and consumers alike, although they closely scrutinize the fortunes of the Dow Jones in New York or the FTSE100 in London. These important yardsticks affect decision-making in financial markets and also in the real economy. Every day trillions of dollars in capital expenditure/project evaluation, risk modeling, and executive remuneration are all directly linked by market indexes. Investment managers also frequently use index derivatives as a simple and efficient alternative to buying and selling physical constituents.

In financial literature and everyday usage, indexes are given the status and importance of scientific instruments although they are far from being the precise or universal constants which exist in fields such as engineering or physics. A market index simply measures the performance of a basket of securities that is constructed in accordance with the index publisher’s methodology. Consequently, an index is a “branded” measure of market performance, where the “market” is whatever the publisher deems it to be.

Although index publishers operate in a competitive marketplace, their index construction methodologies are often similar. Commonly, indexes are weighted according to market value (or capitalization) of their constituent stocks. This weighting scheme is generally regarded as the most accurate reflection of the economic outcomes experienced by all investors in a stock market. This means that once the firms are selected as being representative of the industries in the stock market covered, index performance is calculated using a sum of the individual stocks’ returns weighted according to their size. For example, a stock which has a 5% return and represents 10% of the market capitalization will generate 0.5% of the index return for the period. Other schemes which can be used are equally weighted (where each stock has the same weight and performance contribution to the index return) or price weighted (where higher-priced stocks of have a larger index impact, and vice versa).

Although the performance of competing market indexes may appear to be correlated, these outcomes can mask significant differences in the index construction methodologies used. For example, although the S&P500 Index and the Dow Jones Industrial Average may show similar performance for the US stock market, the former is a capitalization-weighted, broad market index comprising 500 constituents, while the latter is a price-weighted index covering only 30 stocks.

Indexes are typically rebalanced periodically to reflect changes to the stock market and corporate actions which can affect constituent firms (known as “index events”). For example, if an index constituent is acquired by another firm, it will be removed from the index and replaced with a new constituent. The index publisher may review the composition of the index to make sure it remains representative of the market it covers. Indexes are also subject to ad hoc changes arising from market events: for example, when a firm goes into bankruptcy.

In the early 2000s, most global index publishers introduced a “free float” calculation methodology. This reduces a stock’s weighting in an index (and therefore its contribution to the market’s performance) where the availability (or “float”) of securities is restricted due to cross-holdings (a corporation’s holdings of another company’s stock), or untraded ownership stakes held by governments or founders. The adoption of a free float methodology (originally used by the International Finance Corporation for the calculation of its emerging markets indexes in the 1990s) was in part precipitated by the dot com market crash. At that time, many new issues were being included in indexes at their full market capitalization, despite the reality that sometimes less than 20% of the issued shares were actually available to investors for trading in the market.

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History and Rationale for Indexing-Tracking Strategies

Since the late 1960s, researchers have been examining the performance of professional fund managers using risk-adjusted measures, and they have found that the majority have not outperformed the market averages, even before management fees are taken into account.¹ This empirical literature, known as the “active versus passive debate” in academic and practitioner circles, provides persuasive evidence of the concept of market informational efficiency. The consensus emerging from this work provides an important validation of orthodox economic theory, which asserts that financial markets generally function rationally and that security prices reflect fair value.

These research findings also spawned the development of so-called passive or index-tracking strategies in the 1970s. The first index-tracking strategy was created in 1971 by Wells Fargo (now Barclays Global Investors) for a single pension sponsor (Samsonite) and used an equally weighted portfolio. In 1973, it created a comingled fund for its trust department clients which tracked the S&P500 Index. In 1976, the Vanguard Group launched the first US index mutual fund (the Vanguard S&P500 Index Fund). Today there are numerous indexes and index-tracking products, covering stock markets, industry sectors, hedge funds, and commodities. According to Standard & Poor’s, US$4.85 trillion was benchmarked to its US indexes at December 31, 2007: This figure includes US$1.5 trillion directly indexed to the S&P500.

The prudent investment standards which govern many pension funds and institutional investors in Anglo-Saxon economies have, since the late 1980s, largely endorsed the benefits (broad diversification with lower operating costs) of investment indexation compared to active portfolio management. In fact, the general intellectual acceptance of market efficiency has effectively reversed the traditional onus on pension fund trustees and other financial fiduciaries to employ active portfolio management strategies that seek to outperform the market while minimizing risks to capital.

Although index publishers disclaim indexes as being measures of investment merit, market pundits and academic researchers have paid surprisingly little attention to the suitability of market indexes for investment purposes, concerning themselves instead with tests of market efficiency. It is also important to note that indexes are themselves actively managed instruments: Index tracking is therefore not a passive, “buy-and-hold” investment strategy, familiar to most personal investors.

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Market Impacts: Price and Volume Effects of Index Changes

Although indexes have evolved as market measures, they form the underlying basis for index-tracking strategies whose portfolios are managed mechanistically using either full replication (where all constituents are held in their index proportions) or partial replication (a subset of stocks) techniques. Index-tracking strategies are compelled to alter portfolio holdings in accordance with changes announced by index publishers. Significant trading costs (as distinct from operating costs such as brokerage and taxes)—also known as market impact or frictions—can also arise from constituent changes when index funds (and many funds have active managers who also track market benchmarks for active portfolios) rebalance their portfolios.

Because index-tracking strategies involve no judgment or market timing, unlike active portfolio management disciplines, their transactions are price-insensitive. Thus, the growth in the scale of indexed portfolio assets has brought opportunities for arbitrageurs to profit from the potential volatility and liquidity imbalances which are caused by index reconstitution events. For example, arbitrageurs may purchase (or sell) securities due to be included in (or removed from) the index prior to the date of the index event. Index-tracking funds are compelled to buy (or sell) “at any cost” to rebalance their portfolios to the revised index composition.

The direct implications of index reconstitution events have been examined in the academic literature since the mid-1980s. In 1986, Harvard economist Andre Shleifer highlighted the price and volume effects’ implications for stocks in the S&P500 Index.² He concluded that index tracking created downward sloping demand curves due to the price inelasticity of demand created for these stocks. Several subsequent studies in the United States and the United Kingdom have also documented significant price and volume effects for stocks added and deleted from stock market indexes. Other research, however, has found that prices subsequently reverse over longer time horizons. These findings do not acknowledge the costs of price volatility experienced by investors.

In response to the practical concerns of clients and stakeholders, index publishers announce index changes in advance of the actual index reconstitution events. This has had the effect of bringing forward the volatility associated with these changes from the actual index event date.

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Case Study

News Corporation’s Inclusion in the S&P500 Index

News Corporation is an integrated and diversified media company with assets of approximately US$62 billion as at September 30, 2008. The company has global operations but earns the bulk of its income in the United States. In April 2004, its chairman and CEO Rupert Murdoch announced that the company was seeking shareholder approval to consolidate the ownership of its Australian businesses and to move the company’s legal domicile from Australia to the US state of Delaware.

In explaining the change of domicile to shareholders, the directors highlighted the important benefits that were expected to accrue from inclusion of the company in the leading US equity benchmarks, especially the S&P500 Index. They noted that this would:

• correct the “under investment” by US institutions, which only held approximately 52% of its shares compared to peer firms such as Disney (72%), Time Warner (78%), and Viacom (87%);

• increase demand from US institutions that were currently prevented from buying non-US stocks;

• increase trading in the company’s shares, which should narrow the gap between the prices of its voting common stock and nonvoting common stock;

• lower the costs of raising equity in a deeper market: the S&P500 Index’s total market capitalization exceeded US$10 trillion, 20 times larger than the Australian market benchmark, the S&P/ASX 200 Index.

On November 3, 2004, the company announced that its reincorporation had received court approval and that the New York Stock Exchange would become its primary listing. On November 17, 2004, Standard & Poor’s preannounced that News Corporation would be included in the S&P500 index (at the close of trading on December 17, 2004) and that the stock would be removed from its Australian indexes in three additional equal installments. On the date of News Corporation’s reincorporation announcement, and on the days it was phased out of the Australian market benchmark, over 195 million shares worth approximately AU$4.6 billion were traded on the Australian Stock Exchange—approximately one-third of this turnover occurring on the day of the reincorporation announcement alone. Since changing its domicile, the company has raised US$5.15 billion in debt securities and started a US$6 billion stock repurchase program.

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Conclusion

Indexes are an essential tool for measuring financial market performance characteristics. Because there has been a dramatic increase in the scale of funds that directly track market indexes and relative performance monitoring by actively managed portfolios, gaining and maintaining membership of an “index club” is a critically important goal for financial executives.

Compared to nonconstituents, firms included in market indexes have the potential for preferential access to capital, significantly greater research coverage in the investment community, and trading liquidity. Index inclusion can increase demand and stock prices. On the downside, firms excluded from indexes typically lose institutional ownership and can experience considerable price declines in their stocks especially in the short term. The case study shows how the phenomenon of index events creates substantial stock turnover and volatility, despite the reality that no significant changes have occurred in a company’s business operations.

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Making It Happen

• Be index-aware: Membership of the “index club” is important because it confers higher demand for stocks and trading liquidity arising from institutional ownership.

• Find out which stock market indexes cover your firm or your market. What are the inclusion and exclusion criteria used by the publishers, and how is your firm classified in terms of its market value and industry representation? Even if your stock is not included in a broad market index, it may be a potential constituent in an industry-specific or customized index.

• Financial managers need to make sure that index publishers are well informed about their business operations and ownership structures. They should also be aware that index publishers are generally reluctant to delete firms from indexes because this creates excessive index turnover.

• Given that indexes are generally market capitalization-weighted, are profitable merger and takeover opportunities available which will increase the equity base (and thus index size) of the firm?

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Notes

1 For a review of this literature and the debate, see Gold (2007).

2 Shleifer, Andrei. “Do demand curves for stocks slope down?” Journal of Finance 41:3 (July 1986): 579–590. Online at: www.jstor.org/stable/2328486

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