If Stock Picking Is Dead, Then Index Investing Is Completely Broken

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Stock market index-investing has gained enormous popularity, especially via the popularity of exchange traded funds. Old guard indexing giants such as Vanguard are even rolling out S&P500 index ETFs in order to catch the latest wave.

Most investors can’t beat the market and everything appears to trade in the same direction these days, so it’s better to just invest in the entire market blindly, so the thinking goes.

Yet as ETFs and index-investing grow in popularity, the risk is that investors will increasingly buy or sell large baskets of shares without any regard to their underlying fundamentals. Note that stock-picking has already been declared ‘dead’ or pointless by many in the media or investment industries.

Thing is, market distortions caused by index-investors are growing according to research by the National Bureau of Economic Research, via Alphaville [emphasis added]:

On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine per cent around the event, with the effect generally growing over time with Index fund assets. 6 Stocks deleted from the Index have tumbled by even more. Given that mechanical indexers must trade 8.7% of shares outstanding in short order, and an even higher percentage in terms of the free float, not to mention the significant buying associated with benchmarked active management—this price jump is easy to understand and, perhaps, impressively modest.

If a one-time inclusion effect of a few percentage points were the end of the story, then the overall impact of indexing on prices would be modest. But the inclusion effect is just the beginning. The return pattern of the newly-included S&P 500 member changes magically and quickly.

It begins to move more closely with its 499 new neighbours and less closely with the rest of the market. It is as if it has joined a new school of fish.

The S&P 500 Index’s visibility and the easy access to ETFs and Index funds facilitate a high sensitivity of flows to returns.

Keep in mind that at some point everyone can’t be index-investing, else nobody will be left actually analysing stocks for their values. While stocks all fell in unison during the crisis, and have seemed to move in lock-step based on macro concerns lately, that doesn’t mean this will always be the case.

Index investing principles are grounded in the idea that markets are efficient — prices already reflect fair risk-adjusted values for stocks, so you can just buy the entire market and piggy back the investment analysis done by other investors. Yet for markets to be even remotely efficient as index investing requires, markets need stock-pickers out there actually buying based on estimated fair values. This means that sound index investing requires a deep population of stock-pickers out there. Thus the more people shun stock-picking for index investing, the more broken index investing risks becoming. The more popular index investing becomes, the more dangerous it is, because it represents blind buying of huge baskets of stocks.

Meanwhile savvy traders will be taking their slice of profits through arbitrages between blind index fund buying and the stocks which may be added to or removed form an index, or whose price may diverge briefly from what an index fund’s price implies.

Thus while stock picking is out of fashion right now, it’s pretty easy to imagine how in 10 years time we’ll look back and think ‘Wasn’t it just ridiculous how so many people thought that buying the most popular 500 stocks blindly, without any analysis of the companies, was smart?’

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