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Home > Asset Management Best Practice > The Impact of Index Trackers on Shareholders and Stock Volatility

Asset Management Best Practice

The Impact of Index Trackers on Shareholders and Stock Volatility

by Martin Gold

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.

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.

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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Further reading

Books:

  • Ali, Paul, Geof Stapledon, and Martin Gold. Corporate Governance and Investment Fiduciaries. Pyrmont, Australia: Lawbook, 2003.
  • Levy, Haim, and Thierry Post. Investments. Harlow, UK: FT Prentice Hall, 2005.
  • Malkiel, Burton G. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. 9th ed. New York: WW Norton & Company, 2007.

Report:

  • Gold, Martin. “Fiduciary finance and the pricing of financial claims: A conceptual approach to investment.” PhD thesis, University of Wollongong, 2007.

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