John Spence

Do Indexes Influence Markets?

There is mounting evidence that indexes, which theoretically should serve as benchmarks for economic sectors, may actually exert influence on the markets they are designed to track. A growing number of studies are examining whether indexes create or measure market performance.

"As an index committee member, I believe I have more influence over stock performance than active managers," jokes Sandy Rattray of Goldman Sachs International.

When a company is added or deleted from a widely-used index like the S&P 500, the move has consequences for that company's stock price. Research from the 1980s shows that a company's stock sees 2% increase on addition to the S&P 500, and a 2% decrease when deleted from the index. A company's stock jumps when it enters the index because demand for the stock increases from institutional investors with cash tied to that index. With over $1 trillion currently indexed to the S&P 500, stock demand for an added company runs high.

At the recent Superbowl of Indexing conference in Phoenix, Dr. William Goetzmann, Professor of Finance and Management Studies at Yale University, focused on what happened when Molex entered the S&P 500. Molex is a manufacturer of electronic, electrical and fiber optic interconnection products and systems that entered the S&P 500 on 11/29/1999. The first chart below tracks the the stock's performance before and after it was added to the index - the second chart shows Molex trading volume. The spike in trading volume signals the day Molex was added to the S&P 500.

Aside from the dramatic increase in trading volume, the price of the stock also increased in the days following the addition to the S&P 500. But is the increased performance of the Molex stock due solely to its inclusion in the S&P 500? To investigate, Dr. Goetzmann compared the Molex stock to Molex A stock. Molex has two shares - Molex went into the S&P, while Molex A did not.

From the above chart, it can be seen that the two stocks had a strong performance correlation until the beginning of December, when the Molex stock jumped above Molex A. Also, there was no reversion - Molex sustained its higher performance. Although the above chart is a strong example of how inclusion in the S&P can affect a stock's performance, it is just one test case. To further examine how indexes influence markets, it is necessary to delve deeper into Dr. Goetzmann's research.

In March 1999, Goetzmann published a National Bureau of Economic Research working paper entitled Index Funds and Stock Market Growth with Massimo Massa. The two analyzed daily flow data for several Fidelity S&P index funds and found that returns are positively correlated with fund inflows. They also found a strong negative correlation between fund outflows and S&P returns, with the exception of outflows from a fund with very high initial investment requirement. But what is the causality of this phenomenon?

To find out, Goetzmann and Massa examined trailing or "lagging" reaction to market moves. They found that positive returns do not lead inflows, and that negative returns do lead outflows. These results suggest that inflows "cause" returns, and that returns do not "cause" inflows.

When they examined what happens on a daily basis, Goetzmann and Massa found that inflows and outflows in the morning caused price fluctuations later in the trading day. Finally, they did regression studies to determine if returns influenced by fund flows were temporary or permanent, and evidence supported that the effects were permanent.

Dr. Goetzmann believes that the enhanced performance of the S&P 500 Index in recent years may simply be a result of increased inflows into the index as the popularity of index funds increased and more money became tied to the index. Is the S&P 500 a good benchmark considering it is affected in such a way by fund inflows and outflows?

Index providers and investors are waking up to this fact, as witnessed by the MSCI decision to adjust its indexes for free-float (click here to read my recent article on the subject). Free-float is a more objective way of calculating index holdings compared to total market capitalization because free float is based on a company's shares available for purchase, excluding shares held by governments and company insiders.

Finally, Goetzmann believes ETFs may represent an answer to the problem of returns chasing flows because they trade in baskets, and may have a less dramatic effect on markets.