The Mysterious Growing Value of S&P Index Membership
51 Pages Posted: 4 Mar 2002
Date Written: December 2001
The efficient markets hypothesis implies that passive indexing should generate as high a return as active fund management. Indexing has been a very successful strategy. We document a large value premium in the average q ratios of firms in the S&P 500 index relative to the q ratios of other similar firms that appears in the mid 1980s and grows in step with the growth of indexing. Passive investment strategies that require the purchase of the particular 500 stocks in this index increase demand for those stocks and so push up their prices. In short, indexing induces downward sloping demand curves for stocks in the index. For reasons that are not fully clear, arbitrageurs apparently do not correct this overvaluation. However, it would seem that widespread indexing may be undermining the very market efficiency on which it is based. We therefore propose that passive investing be redefined as buying and holding as diversified a portfolio as possible, rather than tracking a particular index. This holistic indexing would have the salubrious effect of spreading passive demand for stocks across the market more evenly, thereby avoiding price distortions of this sort.
Keywords: Market efficiency, indexing, behavioral finance
JEL Classification: G00
Suggested Citation: Suggested Citation