Price efficiency unaffected by growth of indexing, new study suggests

By ALEX MOFFATT

There’s a great deal of debate about the impact of index investing on the overall efficiency of the market. If huge numbers of investors are simply buying up indexes, they aren’t researching the market so in theory price efficiency could be affected. Information that would once have been quickly uncovered by active investors might remain undiscovered.

This could be a big deal, given that over the past two decades the amount of money worldwide going into index investing has grown by nearly $10 trillion, and it’s an issue often raised by those who defend investing in actively managed funds.

However, a newly published paper from the Journal of Financial Economics. On Index Investing by Jeffrey L Coles, Davidson Heath and Matthew C Ringgenberg, argues that in fact, index investing is not having any negative effect on stock pricing.

Free riding isn’t harmful

The authors start by acknowledging that index investors are free riders on the research of active investors. If the entire market were passive then stock prices would not reflect fundamental values and the market would be far from efficient. So we need active investors. But does informational efficiency diminish in line with increased index investment? Their conclusion is a firm no.

The paper examines a sample period from 2007 to 2016 and examines how sudden changes in the mix of passive and active investors causes changes in investment behaviour. The authors find that although a rise in indexing effects investment and information production, “the fraction and effort of informed investor adjust so that the relation between price and fundamental value is unchanged”.

The key to market efficiency lies with that decreasing fraction of the market occupied by active investors. There are two categories of active investors: those who are publicly informed and those who are privately informed. Public information is what’s available to everyone: newspapers, TV, company websites, etc. Private information is harder and costly to come by. As Davidson Heath, one of the report’s authors, explained to me: “It could include not only proprietary data, but also proprietary ways of processing the data that’s out there.”

The incentives to collect private information will vary over time. As Heath puts it, active investors will seek out private information “as long as the expected profits from trading on that information recoup the costs of collecting it, i.e. positive alpha. As they do, they push the stock price toward a more efficient value, and the expected alpha of the next piece of private information will be less.” Thus, they push toward an equilibrium point, beyond which the trade-off of collecting more private data no longer pays.

How individual stocks react

The research uses an old model by Grossman and Stiglitz (1980) in which investors choose whether to pay the cost of becoming informed. This predates the rise of index investing, so the authors build on the model to include three categories of investor choice: whether to be passive, active and publicly informed, or active and privately informed.

To examine the impact of investor behaviour on specific stocks, they follow stocks that switch from the Russell 1000 index to the Russell 2000, because they find that when this switch happens, “ownership by passive index funds increases by approximately 2 per cent of [the stock’s] market capitalisation”, while “ownership by active funds falls by a similar magnitude”. This gives a useful way of examining change at a micro level.

They also find that a rise in index investing leads to a decrease in the total volume of information that investors pay to gather. They track this change by examining Google search volume, EDGAR page views from the Securities and Exchange Commission, and analyst reports. For example, they find the number of analyst reports falls by a marked 10.7 per cent.

But at the level of individual stocks, it turns out that this doesn’t matter. The incentive for active investors to seek out private information is always enough to ensure price efficiency.

A financial incentive for efficiency

The paper isn’t saying index investing has zero effect on the behaviour of the market. It finds that higher levels of indexing causes stocks to have higher share turnover, higher correlation with the broad index and higher volatility. But the fundamentals of price efficiency are unaffected.

If the authors are right, then there need be no cause for concern if index investing continues to grow in popularity, as the remaining pool of active investors will always have the financial incentive to uncover the private information that ensures price efficiency.

So the bottom line for investors remains, as Warren Buffett has frequently argued, stick with low-cost index funds.