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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:

  • The top-performing stock gained more than 160 percent
  • Four stocks had returns over 100 percent
  • 20 stocks had returns of over 60 percent
  • 67 stocks had returns of more than 36 percent
  • 98 stocks had negative returns
  • 40 stocks had lost at least 10 percent
  • 20 stocks had lost at least 20 percent
  • Nine stocks had lost at least 30 percent
  • The worst performer had lost more than 67 percent
  • The dispersion of returns between the top and bottom performers was about 230 percent

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.

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