Is indexing ruining the stock market?

(MoneyWatch) One of the more persistent themes we're hearing from Wall Street and the financial media is that increased investor use of indexes has caused individual stocks to become more correlated, greatly reducing the benefits of diversification. If true, this would make it more difficult for active fund managers to pick winning stocks. Since we're in the myth-busting business, we'll demonstrate how misguided that idea is.

If the trend toward indexing was causing prices to move in tandem, the dispersion of returns (or gap between top performer and bottom performer) of stocks within the same index would be quite low. The reason is that index funds market cap weight their stock purchases. Thus, the price impact on each of the stocks should be pretty similar. On the other hand, if active managers are driving prices, the dispersion of returns will be high.

To see which view is correct, we'll look at the year-to-date returns of the stocks in the S&P 500. Data is as of Sept. 24. Vanguard's 500 Index Fund (VFINX) had returned 17.8 percent. The following facts reflect on the amount of dispersion in returns among the individual stocks in the index:

It's pretty clear that indexers are not driving prices. Active managers will have to come up with another lame excuse for their persistent failure, as this dog won't hunt.

Image courtesy of taxbrackets.org

[maynardGkeynes]

I think the claim is that, due to indexing, beta has come to explain a disproportionate share of the price move of any individual stock. This is a problem for investors/stock pickers, and it undercuts price discovery, which is the raison d'etre of efficient capital markets.

[LarryswedroeCBS]

Michael
Every year without fail, no matter whether markets are rising or falling, active managers lose to indexing when properly measured against the right benchmarks. And every year they come up with some excuse like if only there was or wasn't some event, if only, if only, blah blah blah. And they then say that next year will be a stock picker's year.
What we have heard in recent years is that the high correlation of stocks is the excuse. After all, they have to have an excuse for their failure.

Well the three articles I wrote on subject, this one, the one on commodities and the one on small stocks demonstrates how nonsensical the claim is, just as their other explanations are.

Remember, for them to admit that passive investing is the superior strategy is the equivalent of committing economic suicide, something few people will do without being pushed

Larry

[Michael James on Money]

Thanks for the replies. I understand the nature of the claims made about indexing increasing correlation. What I find puzzling is that a proponent of active investing would say this publicly. An attentive investor who believes the claim would see it as further evidence that he or she should choose passive investing. It's like a car saleman adressing prospective customers and bemoaning the fact that the guy across the street sells better cars.

[Michael James on Money]

Hi Larry,

Even if we ignore the question of whether indexing really does ruin the stock market, I don't understand the motivation for making this claim. Do those who make money when investors choose an active investing approach seriously think that individuals will abandon indexing for some peculiar sort of common good? Maybe they are just trying to attach a negative idea to indexing and hope that inattentive investors will think this means that indexing produces poor returns?

Michael James