How does growth in capitalization-weighted equity index investing affect the stock market? In the December 2014 update of their paper entitled “Indexing and Stock Price Efficiency”, Nan Qin and Vijay Singal examine the relationship between equity index investing (driven passively by liquidity trading and index changes, not actively by information) and stock price efficiency. They estimate equity index (passive) investing from holdings of 591 equity index mutual funds, enhanced index mutual funds, exchange-traded funds and closet indexers. They measure each stock’s passive (non-passive) ownership as the percentage of shares held by these funds (other funds) at the end of each quarter, with the lower bound of passive (non-passive) trading volume the absolute quarterly change in holdings of these (other) funds. They measure stock price efficiency by: (1) magnitude of post-earnings announcement drift (response to new information); and, (2) intraday and daily deviations of price from a random walk. Each quarter, they relate these measures of price inefficiency to level of index ownership across stocks. Using intraday and daily return, earnings announcement and quarterly fund holdings data for S&P 500 Index stocks and size/turnover-matched stocks during 2002 (post-decimalization) through 2013, they find that:
- The percentage (equity market share) of U.S. equity mutual and exchange-traded funds that is passive increases from 12.8% (2.8%) in 2002 to 27.5% (7.1%) in 2013.
- On average, annual share turnover driven by passive (non-passive) funds is 4.0% (79.7%).
- Post-earnings announcement drift increases (decreases) with the level of passive (non-passive)
fund ownership of a stock. This finding is robust to different definitions of price drift, different drift windows and alternative measures of earnings surprise. - Deviation of stock price evolution from a random walk increases (decreases) with passive (non-passive) fund ownership.
- The growth in passive investing probably reduces pursuit of firm information. It may also suppress arbitrage as informed investors lose confidence that prices will revert to efficiency.
In summary, evidence suggests that stocks with relatively high levels of index fund ownership are less efficiently priced than other stocks, and growing use of index funds is widening this efficiency gap.
Cautions regarding findings include:
- The study does not test the indexing-efficiency relationship at a market level.
- The study does not quantify consequences for stock trading strategies that seek to discover stock price inefficiency and exploit reversion to efficiency.
For another perspective, see “The Decline of Stock Picking?”.
