Does indexing create market distortions or reduce them?

Posted by Robin Powell on December 7, 2018

Does indexing create market distortions or reduce them?

We have written several times about attempts by sections of the financial industry to discredit passive investing and to sow fear in people’s minds about the effects that its growing popularity might be having.

A good example is the notion that the rise of indexing is causing distortions in the markets. But is it actually true? Globally, passive investing still accounts for a small proportion of assets under management, and the vast majority of trading (or price-setting, if you like) is still done by active managers. Indeed, there are far more trades being placed today (thousands every second) than ever before.

In fact, you could argue, the growth in passively managed assets is helping to reduce market distortions and make markets even more efficient. For example, by raising the bar for active managers, and putting ever more pressure on them to outperform net of costs, it’s forcing the least skilful and the most expensive managers out of business. In theory, it’s the best (or perhaps more accurately the least worst) managers that survive, which should mean better price-setting.


New study

Now a new study points to another way in which the rise of passive is adding to market efficiency. The paper is called The Weakening Index Effect, and it was written by Anthony Renshaw, Director of Index Solutions at the analytics provider Axioma. It has yet to be published, but I’ve seen the final draft and the findings are interesting and rather surprising.


The index effect

The index effect refers to the way in which stocks that join an index generally experience positive excess returns in the days immediately before they’re officially added to it, while stocks that are removed from an index tend to fall in price in the run-up to their formal removal.

Historically, the index effect has produced a market distortion. Generally, an index will announce that a stock is about to join or leave about five days before it happens, allowing traders to profit. For example, they’ve been able to profit by buying up stocks that are about to leave in the expectation of being able to sell them at a profit to passive fund mangers who are compelled to buy them when they do so — a strategy that’s sometimes referred to as index front running.

Intuitively, you might expect the index effect to become increasingly pronounced as more and more of us choose to invest passively. But Axioma found that, on the contrary, the effect has actually become less pronounced over the last ten years, at least in the large- and mid-cap sectors. The most noticeable decline, it observed, came in 2009, just as ETFs began to surge.


Cause and effect

Of course, there is a possibility that the weakening index effect and the rise of passive investing are unconnected. Renshaw concedes that the low volatility, reduced trading costs and generally strong returns we’ve seen in recent years may in part explain why the index effect has become less of an issue.

But, he told the Financial Times, “it would be very surprising if the passive investing market and, in particular, the ETF market, didn’t play a major role.”


Possible explanation

One of the ways that the growth of indexing has helped to reduce the index effect, Renshaw argues, is through the role of so-called authorised participants, or APs. These are the financial institutions that create and redeem ETF shares.

APs buy up stocks in the days before they’re due to drop out of the index, because they can make a profit by exchanging them for shares of the ETF. In doing so, they not only prop up the price of these stocks and diminish the index effect, but also provide liquidity.

So, there you have it — more proof that passive investing isn’t the force for evil and market mayhem that some would have us believe.

To read the full report, you will need to subscribe via the Axioma website.

Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.


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