Does the Growth of Passive Investing Make Opportunities for Active Investors?

Asset growth in index funds and index ETFs has been remarkable in recent years, so one might naturally wonder what this trend means for investors using active strategies--that is, choosing individual stocks or hiring a fund manager to do so as opposed to buying stocks in an index-defined basket. In particular, how does being part of an index affect the prices of individual stocks in that index, and does this create opportunities for active investors?

At first blush, one might not expect the increased use of index funds and ETFs to have any impact at all on active investors. After all, isn't everyone investing in the same market, and isn't that market pretty efficient at pricing stocks? The answer isn't quite so cut-and-dried, however.

To see why, consider that a stock that is included in a major index--such as the S&P 500--gets a boost from the millions of dollars that flow into it from funds that must own the stock in order to track the index. For example, let's say Acme Rocket Company is priced at around $10 a share and is not part of any major index, so only investors interested in owning the company at that price buy its stock. But once Acme Rocket Company is added to an index, suddenly investors who know nothing at all about the company's fundamentals or care much about its specific performance begin buying shares through the index funds they own. Suddenly its stock price rises as a result of this new demand, yet this demand is based on nothing more than the stock being included in an index.

Index Inclusion Pushes Up Stock Prices
This stock price inflation as a result of being included in an index is very real. In fact, a 2012 academic paper (subscription required) estimated that asset flows into funds and ETFs tracking the S&P 500 boost the valuation (price-to-earnings ratio or price-to-book ratio) of stocks included in the index anywhere from 139 to 167 basis points as compared to stocks left out of the index. Furthermore, the authors conclude that this boost does not dissipate over time. For perspective, NYU finance professor Jeffrey Wurgler estimated in 2010 that the average constituent of the S&P 500 was 9% owned by index funds, a figure that has likely grown as assets have continued to pour into passive investment vehicles.

This price boost from joining an index is far from a secret. In fact, front-running a stock's inclusion in an index by buying shares in anticipation of this event, or selling those that may get the boot, has become a popularly used investment strategy (though indexers have taken steps to reduce its impact).

No Clear Advantage Seen for Active Investors
If so much money is flowing into some stocks based not on their merits but solely on their inclusion in an index, and boosting their stock prices in the process, does that mean there are opportunities to exploit price distortions? The answer is unclear, but a group of Morningstar analysts and researchers we spoke with were skeptical.

"I'd say probably not," said ETF analyst Sam Lee. "There are some edge cases, where index funds can distort prices when they reconstitute. For example, traders try to predict which stocks will get booted out of or added to the Russell 2000 index, and front-run any anticipated moves by the index. This has cost Russell 2000 investors perhaps 1% annually."

One reason that price distortions created by indexing may not present much if any of an opportunity for active investors is that active investors themselves serve as a counterbalance to correct them, said ETF analyst Mike Rawson. For example, even as technology stocks soared in value and became a sizable percentage of the major market indexes in the late 1990s, savvy value-oriented managers downplayed them. That move paid off as tech shares tumbled between 2000 and 2002.

"Index investors rely on fundamental [active] managers to keep security prices in line with fundamental valuation," Rawson said. "In theory, it would only take one profit-seeking active manager to correct any security mispricing and keep security prices in line with fair values. However, this sort of arbitrage takes risk, and true fair values are never known with certainty."

Market Dynamics Unchanged
Morningstar's Paul Kaplan said that, even given the rise of indexing, the market still requires a buyer and a seller to set a stock's trading price, and that hasn't changed. He said active traders tend to benefit by trading with other investors who are chasing market performance, and that that dynamic is unlikely to be affected by more investors using passive strategies. Like Rawson, Kaplan pointed out that it's impossible to say whether stocks that are priced higher due to their inclusion in an index are overpriced, because stocks don't have irrefutable true values. "All that a valuation is, is an opinion," he said. "You can't point to any value of a stock and say 'That's the true one.'"

Given that index funds still represent a minority of market assets, their effect on valuations remains limited, at least for now, Rawson said.

"I think we are a long way from the point where the amount of assets in index funds becomes destabilizing," he said. "If we are at 30% of assets in index funds currently, that number would need to account for a much larger percentage of managed assets. Before we get to that point where things become less stable, a natural balance between index and active will develop."

James Xiong, a senior research consultant at Morningstar Investment Management, has studied the effects that the increased use of index funds have had on the market, including their role in rising correlations and overall market risk (as he discusses in this video). Xiong says the question of whether increased indexing creates exploitable opportunities for active investors remains open. "My guess is that it will provide some opportunities for active managers, but they might have to wait for a while for the market correction depending on how dominant the index trading [the stock] is," he said.

For now, at least, it appears that stocks that are included in major indexes do enjoy a boost to their market valuations, but whether this presents an opportunity for active investors is far less certain.