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The impact
The impact of passive investing of passive
on corporate valuations investing
Eric Belasco
Department of Agricultural Economics and Economics, 1067
Montana State University, Bozeman, Montana, USA
Michael Finke Received August 2012
Revised January 2012,
Department of Personal Financial Planning, Texas Tech University, March 2012
Lubbock, Texas, USA, and Accepted May 2012
David Nanigian
The American College, Bryn Mawr, Pennsylvania, USA
Abstract
Purpose The purpose of this paper is to explore the impact of S&P 500 index fund money flow on
the valuations of companies that are constituents of the index and those that are not.
Design/methodology/approach To examine the impact of passive investing on corporate
valuations, the authors run panel regressions of price-to-earnings ratio on aggregate money flow into
S&P 500 index funds and control for various accounting variables that impact price-to-earnings ratio.
These regressions involve two samples of stocks. The first sample consists of S&P 500 constituents.
The second consists of large-cap stocks that are not constituents of the S&P 500. The authors also run
a set of separate regressions with price-to-book ratio rather than price-to-earnings ratio as the
dependent variable.
Findings It is found that the valuations of S&P 500 constituents increased by 139 to 167 basis
points relative to nonconstituents, depending on valuation metric, due to S&P 500 index fund money
flow when evaluated at mean values of money flow and valuation metrics. The valuations of firms
within the S&P 500 index respond positively to changes in S&P 500 index fund money flow while the
valuations of firms outside the index do not. Additionally, the impact of money flow on valuations
persists the month after the flow occurs, suggesting that the impact does not dissipate over time.
Practical implications Mispricings among individual stocks arising from index fund investing
may reduce the allocative efficiency of the stock market and distort investors performance evaluations
of actively managed funds.
Originality/value The paper is the first to explore the long-run relationship between S&P 500
index fund money flow and corporate valuations.
Keywords Investments, Indexing, Fund management, Active management, Passive management,
Index fund, Index premium, Demand curves for stocks, S&P 500
Paper type Research paper
JEL classification G11 (investment decisions), G12 (asset pricing), G23 (private financial
institutions)
The authors appreciated the feedback given by Ozzy Akay, David Blitzer, Dale Domian,
Harold Evensky, Scott Hein, Jason Hsu, Vitali Kalesnik, Masha Rahnama, John Salter, William
Waller, and Walter Woerheide, and the excellent research assistance provided by Melissa Cenneno.
Managerial Finance
The authors also thank seminar participants at Texas Tech University (hosted by the Division of Vol. 38 No. 11, 2012
Personal Financial Planning) and The American College, as well as participants at the Academy of pp. 1067-1084
q Emerald Group Publishing Limited
Financial Services Annual Meeting, the Financial Management Association International Annual 0307-4358
Meeting, and the Journal of Indexes Editorial Board Meeting for their comments and suggestions. DOI 10.1108/03074351211266793
MF I. Introduction
38,11 Neoclassical asset pricing theory assumes that the price of a stock changes as a result
of new information about a corporations value to its shareholders. Event studies
on changes to the composition of an index are frequently used to examine whether a
non-valuation motivated change in the quantity demanded of a given security results in
a change in its price. While these studies suggest an increase in valuation resulting from
1068 inclusion in the index, it is possible that the increase accurately reflects greater intrinsic
value of the stock from increased liquidity. This study explores the impact of S&P 500
index fund money flow on the valuations of companies that are constituents of the index
and those that are not. We find that money flow increases the price-to-earnings and
price-to-book ratios of companies that are constituents relative to those that are not. This
provides evidence of downward-sloping demand curves for stocks.
In a broad review of studies investigating indexation price effects, Brealey (2000)
identifies a trend over the period 1966 to 1995 toward larger positive abnormal returns
following the addition of a stock to the S&P 500 and larger negative abnormal returns
following a deletion of a stock from the index. Petajisto (2011) finds that the average
abnormal returns to additions are 8.8 percent in the period 1990 through 2005, and the
average abnormal returns to deletions are 2 15.1 percent. The percentage of US equity
mutual fund assets invested in index funds increased from 1.0 percent in 1984 to 12.4
percent in 2002 (French, 2008), and more than half of all US equity index fund assets
are invested in S&P 500 index funds (Investment Company Institute, 2011). This
increase in passive equity investment among S&P 500 firms suggests that the growth
of the event effects may be largely due to the shift toward passive investing.
The slope of a demand curve for a companys stock is gauged by the (absolute)
magnitude of its price elasticity of demand, E DP . In the stock market setting:
DQ=Q
D ;
E P 1
DP=P
where Q denotes the quantity of shares of a companys stock demanded by investors and
P denotes the price per share of the companys stock.
This concept is shown in Figure 1.
Shleifer (1986) and Petajisto (2011) estimate that E DP is near unity. This runs contrary to
the predictions of Famas (1970) efficient market hypothesis, which predicts that
arbitrage trading will correct mispricings among stocks[1]. Arbitrageurs have not
flattened the demand curve. Petajisto (2011) also discovers that in the period 1990
through 2005 the average abnormal returns to additions to the Russell 2000 was
8.0 percent and the average abnormal returns to deletions was 2 13.4 percent. Price
effects in the purely market cap-based Russell 2,000 that are similar to those observed in
the S&P 500 provide further evidence of downward-sloping demand curves for stocks.
In a related strand of research, Baberdis et al. (2005) theorize that, in the presence of
limited arbitrage, money flowing into a segment of the market impacts the correlation
of returns between stocks in that segment. Consistent with the authors habitat theory
of return comovement, they find that a stocks correlation with other stocks in the S&P
500 increases when it is added to the index and, commensurate with the trend towards
S&P 500 index fund investing, the correlations have increased in recent years.
Relatively higher stock ownership by active funds reduces the magnitude of the
correlation between stocks and the index; however, index additions result in increased
S The impact
D0 D1 of passive
investing
Price (per share of stock)
P1
1069
P0
passive ownership share and a decrease in firm-specific price changes (Ye, 2011).
Wermers and Yao (2011) find stronger pricing anomalies, such as those related to
momentum and accruals, among stocks with high levels of passive fund ownership,
which provides additional evidence that index fund investing impedes the efficiency of
capital markets. Increasing correlation among funds within the S&P 500 and pricing
anomalies associated with increased passive investment may counteract alternative
explanations for the gains from S&P 500 inclusion, including reduced agency costs
from increased monitoring by analysts (Yu, 2008).
Event studies only partially address price effects associated with index fund investing.
This is because investor cash is continuously flowing in and out of index funds, yet
changes to the composition of an index only occur a few times a year. Changes in the
quantity of a stock demanded by index fund managers as a result of fund flows may also
impact the price of stocks if stocks within the index exhibit downward-sloping demand
curves. Goetzmann and Massa (2003) examine the relationship between index fund flows
and returns on the index and find that a strong same-day relationship exists. However, it is
difficult to determine whether the flows are driving the returns or vice versa. To
disentangle demand effects from potential feedback effects, the authors perform a
Geweke-Messe-Dent (1982) (GMD) test. The GMD test confirms that the direction of
causality is from flows to returns. However, the GMD test is weak if the causality is at a
higher frequency than the data. This motivated the authors to conduct a series of tests
using higher frequency data, which arrive at the same results as the GMD test. Hence,
strong evidence suggests that flows drive returns. However, the question of whether or not
S&P 500 index fund money flow has inflated the fundamental value of companies that are
constituents of the index relative to nonconstituents has not yet been determined.
MF We hypothesize that flows into S&P 500 index funds positively impact the PE ratio
38,11 of companies that are in the index relative to those that are not. In an unpublished
manuscript, Morck and Yang (2002) find evidence that money flow into index funds
alters the Tobins Q ratios. Our empirical work is an extension of Morck and Yang and
is different in several ways. First, we perform regressions that involve net cash flows
(NCF) rather than time-series plots. Second, we take a comprehensive view of index
1070 fund assets by looking at all S&P 500 index funds, including exchange traded funds
(ETF). Third, we focus on ratios that are more commonly used by practitioners to
gauge valuation. Fourth, we use more recent data. This paper examines the extent to
which price multiple measures of valuation are impacted by the trend toward passive
investing. To conduct this analysis, we run panel regressions of price-to-earnings ratio
(PE) on aggregate NCF into S&P 500 index funds controlling for various accounting
variables that impact PE. Additionally, regressions are run with price-to-book ratio
(PB), an alternative valuation measure, as the dependent variable[2].
The results from regression models that control for aggregate US equity fund NCF
demonstrate that the valuations of constituents increased by 139 to 167 basis points
relative to nonconstituents, depending on valuation metric, due to S&P 500 index fund
NCF when evaluated at mean value of NCF and valuation metrics. Valuations of
firms within the S&P 500 index respond positively to changes in S&P 500 NCF while
the values of firms outside the index do not increase during the same time period.
Additionally, flow induced price-pressure effects do not appear to dissipate over time.
II. Data
To maximize coverage of index fund assets, we incorporate both mutual fund and ETF
data into our analysis. Mutual fund and ETF data come from Morningstar Direct.
Index and individual stock data come from Compustat. Because Morningstars
coverage of fund flows begins in February 1993, we control for lagged one-month fund
flows, and because Compustats price-dividends-earnings file ends in February 2007,
the sample period spans March 1993 to February 2007.
III. Methods
A series of least-squares regressions is used to analyze the impact of money flow into
S&P 500 index funds on the valuation of individual companies. Our choice of a panel
study involving individual companies in contrast to time-series analysis involving
portfolios of stocks was driven by two rationales. First, the panel study approach
allows us to better control for effects across the cross-section and time domains.
Second, more information is utilized through the panel approach as our results are not
limited to a single portfolio or a moment in time.
We employ a fixed effects model with a one-way error term in our regression analysis
to account for company-specific individual effects. The use of this model is supported by
the results from the Hausmans specification test for fixed versus random effects.
MF A. Description of regression model
38,11 To test our hypothesis, we estimate regressions that are variants of the following form:
IV. Results
Table I presents summary statistics on the main variables of interest. NCFs are
reported in billions of dollars. It is interesting to note that S&P 500 index fund NCFs
are relatively more volatile than those of the aggregate market of US equity funds. For
example, the standard deviation of S&P 500 index fund NCF is 2.25 times greater than
its mean value, yet the standard deviation of aggregate US equity fund NCF is only
0.90 times the size of its mean value. The factors that affect aggregate US equity fund
NCF, such as aggregate demand for liquidity among market participants, also affect
S&P 500 index fund NCF. However, the Pearson correlation coefficient between the two
money flow variables is only 0.55. The correlation coefficient is not indicative of
multicollinearity, suggesting that the increased popularity of indexing over our sample
period, in addition to market-wide factors, contribute to the high volatility of S&P 500
40,000,000,000
Aggregate US equity fund NCF
30,000,000,000
S&P 500 index fund NCF
20,000,000,000
10,000,000,000
0
Mar-93
Mar-94
Mar-95
Mar-96
Mar-97
Mar-98
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
(10,000,000,000)
(20,000,000,000)
(30,000,000,000)
(40,000,000,000)
Notes: This figure plots the time-series of aggregate NCF into US equity funds
and into the subset of such funds that Morningstar categorizes as having an
objective of tracking the S&P 500 Index; the sample period spans March Figure 2.
Time plot of money flows
1993-February 2007
MF
38,11
1074
Table II.
1993-February 2007)
Price-to-earnings ratio
regression results (March
Constituents Nonconstituents Constituents Nonconstituents Constituents Nonconstituents Constituents Nonconstituents
(1) (2) (3) (4) (5) (6) (7) (8)
1076
Table III.
Price-to-book ratio
1993-February 2007)
regression results (March
Constituents Nonconstituents Constituents Nonconstituents Constituents Nonconstituents Constituents Nonconstituents
(1) (2) (3) (4) (5) (6) (7) (8)
C. Subperiod analysis
Tables IV and VI provide subperiod results for March 1993 through February 2000 for
price-to-earnings ratio and price-to-book ratio, respectively. Tables V and VII provide
subperiod results for March 2000 through February 2007 for price-to-earnings ratio
and price-to-book ratio, respectively. Although the impact of NCF on valuation is
statistically significant and positive among constituent firms in both sub-periods, the
effect is more pronounced between 1993 and 2000. This may be due to heavier inflows
into index funds during this period (the fraction of total US equity mutual fund assets
tracking the S&P 500 increased by 151 percent between 1993 and 2000 versus
29 percent between 2000 and 2006). The more pronounced effect in the first subperiod
may also be due to the increased popularity of day trading over that period (Tables VI
and VII).
As in the full period analysis, the subperiod analysis also does not provide much
evidence to show that fund money flow explains much of the total variation in
corporate valuations but the analysis also does not show that flow induced valuation
effects dissipate over time.
V. Concluding remarks
A. Summary of research findings
This study is the first to explore the long-run relationship between S&P 500 index fund
money flow and corporate valuations. Through a series of panel regressions, we
examine whether money flow into S&P 500 index funds impacts the price-to-earnings
ratio and price-to-book ratio of firms within and outside the index. The results are
consistent with the hypothesis that money flow into S&P 500 index funds positively
impacts the price multiples of companies that are in the index relative to those that are
not. The impact on valuations persists the month after the flow occurs, suggesting that
the impact does not dissipate over time. These results are consistent with the theory
MF
38,11
1078
Table IV.
1993-February 2000)
Price-to-earnings ratio
regression results (March
Constituents Nonconstituents Constituents Nonconstituents Constituents Nonconstituents Constituents Nonconstituents
(1) (2) (3) (4) (5) (6) (7) (8)
1993-February 2000)
regression results (March
Table V.
Price-to-book ratio
1079
MF
38,11
1080
Table VI.
2000-February 2007)
Price-to-earnings ratio
regression results (March
Constituents Nonconstituents Constituents Nonconstituents Constituents Nonconstituents Constituents Nonconstituents
(1) (2) (3) (4) (5) (6) (7) (8)
2000-February 2007)
regression results (March
Price-to-book ratio
Table VII.
1081
MF of downward-sloping (i.e. not horizontal) demand curves for stocks and suggest that
38,11 money flow from index funds can distort stock prices.
Notes
1. See, for example, Shleifer (2000) for a discussion of this hypothesis.
2. Some advantages of PB ratio are that it provides more meaningful valuation estimates in the
event that earnings are negative and book values tend to be less volatile than earnings.
However, it is important to bear in mind that one downside of book value is that it does not
consider human capital as an operating factor. Additionally, it is difficult to compare
companies in different industries based on PB ratios due to differing levels of hard asset
intensity across industries.
3. Details on the methods employed by Morningstar to estimate net cash flows can
be found at: http://corporate.morningstar.com/us/documents/Direct/INS_MDT_
EstimatedNetFlowsMethodology.pdf
4. Non-operating establishments are detected through industry name. Following the method
of Petersen and Rajan (1997), financial services companies are considered to be those with
a Standard Industrial Classification code ranging from 6,000 to 7,000. ADRs, ADSs, AMs, The impact
and GDRs are detected through the company name (i.e. ADR in a company name indicates
that the security is an ADR). of passive
5. For a discussion of how these factors impact valuations, see Koller et al. (2005) and investing
Damodaran (2007).
6. Alexander et al. (2007) find that valuation-motivated trades by mutual fund managers
outperform non-valuation motivated trades, and that this outperformance was greater in the 1083
more recent period (1992-2003) than it had been between 1980-1991. The increased
magnitude of the effect over a period characterized by a preference shift towards passive
investing lends some credence to Grossman and Stiglitzs (1980) theory.
7. De Long et al. (1990) suggest that this is because investors evaluations of professional
money managers often occur over short time intervals. Gromb and Vayanos (2010) provide a
detailed review of the literature on the limits of arbitrage.
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Corresponding author
David Nanigian can be contacted at: david.nanigian@theamericancollege.edu