In this segment, I argue that passive index creates index zombies that survive because of relatively guaranteed demand for their stock from indexers. I also hypothesize that indexing reduces the production of value relevant information to price stocks by active investors.
Movie poster to the film "Curse of the Undead." Art by Reynold Brown (1917-1991). Artist William ... [+]
3.0 How much of a social cost does indexing impose?
What is good for individual investors like me you and me may not be as good for the system. My thesis is that index investing creates a disconnect between the providers of capital (you and me via 401ks and other investment accounts) and the CEO or the CFO of the firm which “gets” this capital. I have written about whether anyone has really met the real “shareholder” (you and me not the Big Three) when corporate managements talk about shareholder value. This is not to say that we don’t have retail investors who still buy individual stocks, but most of the stock held by individuals is via indexes in their defined contribution (401k) plans.
3.1 Index zombies do not have to fight for capital
The biggest cost of passive indexing might entail subsidizing firms who do not have to fight for capital as being in the index guarantees demand for their shares without having to work very hard for it. Absent such demand, share prices of these zombies would have fallen faster than in a counterfactual world without such rampant indexing.
A textbook example of such a subsidy is IBM in the S&P 500 index. IBM has underperformed the S&P 500 by around 80% over the last 10 years. Yet, the top three owners, BlackRock, Vanguard, and SSGA, continue to collectively own around 25% of the company and its not obvious what they have done to get IBM management to address such underperformance. You could argue that ultimately, fundamentals will have to catch up with weak companies. Yes, and no. If a firm keeps losing cash flow, eventually its market capitalization shrinks, and it gets thrown out of the S&P 500 perhaps only to migrate to the S&P 600 mid-cap world. However, if the firm generates stable cash flows like IBM without much growth in revenue, it can stay an “index zombie” for a long time.
Of course, you could argue that not every company must keep growing by leaps and bounds. There are plenty of active value investors who love steady-eddy companies with stable cashflows such as utilities. Of course, my point is simply that in a counterfactual world with not as much rampant indexing, such zombies would have far lower valuations and hence lower market to book or price-earnings ratios.
In a world without passive indexing, bad news about absence of revenue growth at IBM might have been priced in more rapidly. Hence, IBM’s stock might have under-performed by even more than 80% which, in turn, might have forced the board and management to take its bitter medicine much earlier. IBM is not the only index zombie. I have not run the numbers (in progress for a research project) but airlines such as Delta, and American or retailers that have been “Amazoned” away such as Nordstrom and Macy’s would perhaps have restructured their businesses earlier, had they not been part of the S&P 500. But this argument, by itself, creates an opening for activists such as Elliot to flourish. We will come back to that later.
The flip side of this problem is over-valuation. A textbook example is the introduction of Tesla to the S&P 500. During the summer of 2020, after Tesla had reported four consecutive quarters of profit, the S&P Dow Jones Committee decided to add Tesla in November 2020 to the S&P 500. That decision triggered frenzied buying and ended up raising Tesla’s market capitalization from around $100 billion to $650 billion!
Tesla’s equity, as of May 3, 2023, was worth $508 billion. How does that compare with its 10 closest competitors? BYD, the Chinese EV maker, was worth $99 billion, followed by Mercedes-Benz group for $83 billion, BMW at $72 billion, Ford at $47 billion, GM at $46 billion, Honda at $44 billion, Hyundai at $35 billion, Kia at $26 billion and Renault at $9 billion. That is, Tesla is worth more than its 10 competitors combined ($461 billion).
You could come back and ask, “How do you explain the decline in Tesla’s stock price more recently, since they are still in the S&P 500?” Well, the calculations of market caps of competitors that I went over is based on today’s valuations. And my argument is not that an indexed firm will never experience stock price declines. I simply suggest that prominent index members will be overvalued with rampant indexing.
A skeptic can also ask, “Why are the bulk of the S&P returns this year accounted for by only the largest companies? Surely all 500 companies in the S&P 500 should have risen by the same percentage if indexers are driving the bus.” If anything, this objection arguably supports my case. To understand why, we need to get into the plumbing of the S&P 500.
The S&P 500 is a market cap float adjusted weighted index. The number of shares available for trade is first divided by the number of outstanding shares. That ratio is then multiplied by the market value of the firm’s equity to determine the company’s weight in the index. Bottomline, this simply means that if I send one dollar to buy the S&P 500 ETF, 20 cents would be used to buy just five stocks (Apple 7 cents, Microsoft 6 cents, Amazon 3 cents, Nvidia and Alphabet, roughly 2 cents each). Persistent demand for the S&P 500 index will potentially make these large stocks larger partly because more money will chase the same number of publicly available floated shares. This problem becomes worse when large firms buy back stock as that decision reduces the number of shares in the public float.
Having said all this, if you are a skeptic you will continue to argue that I have cherry picked anecdotes without having provided any concrete systematic evidence. Well, such evidence (albeit indirect), is beginning to emerge. Brogaard et al (2018) study the impact of index investing on firm performance by examining the link between commodity indices and firms that use index commodities. They find that “firms that use index commodities make worse production decisions, earn 40% lower profits, and have 6% higher costs.” They go on to state, “consistent with a feedback channel in which market participants learn from prices, our results suggest that index investing distorts the price signal thereby generating a negative externality that impedes firms' ability to make production decisions.” Qin and Singhal (2000) find that “greater indexing leads to less efficient stock prices, as indicated by stronger post-earnings-announcement drift and greater deviations of stock prices from the random walk.”
For the uninitiated, post-earnings announcement drift is a well-known anomaly in “rational” pricing of assets in that earnings surprise seems to be systematically correlated with stock prices of that firm many quarters later although the efficient markets hypothesis would predict that news embedded in that earnings surprise should have been reflected right away in stock prices. A random walk simply states that, in an informationally efficient stock market, changes in stock prices in prior period ought not to be correlated with future changes in stock prices. Sammon (2022), finds “the rise in passive ownership over the last 30 years has caused the amount of information incorporated into prices ahead of earnings announcements to decline by roughly 16%.”
3.2 “There is nobody home”
Closely related to the “don’t have to fight for capital” issue is whether stocks have been informationally inefficient after indexing took off in a big way. The theoretical case for this is stated in the well-known Grossman-Stiglitz paradox which effectively hypothesizes that markets can be informationally efficient only if we have a critical mass of active managers trying to find mispriced stocks. If there are too many passive investors, markets can't be efficient. If this is too abstract, consider the observations of David Einhorn, the legendary short seller and investor, who shares several pertinent and thoughtful comments on this issue:
3.2.1 Comparing how trading in late 1990s to today:
“Very few that are (trading) actually base that decision based on what they think the company is actually worth. That robust debate has essentially left the building.”
To be fair, this statement could apply to other traders besides indexers such as quants, high frequency traders, meme stock traders, and the like as well.
3.2.2. Ignored mid and small caps:
“The number of professionals that are paying attention to mid- and small companies that are not in the sexiest areas of the market, I think it has to be down by some big percentage, but I can't prove that.”
As I have mentioned in my prior piece, that’s an opening for long term active, as opposed to activists, to focus on. This comment also raises an interesting question about how sell side analysts how evolved in a world of passive indexing. More on that later.
3.2.3 On the difficulty of arbitraging informational inefficiencies out:
“Last couple of years, I've had the realization that with some of these stocks, nobody's ever going to care. Nobody is paying attention, nobody is doing the work, nobody cares what the company says. There's just nobody home.” This really hit home for me in my “who reads a 10-K” piece. To quote a friend of mine, “A tree falling in a forest with no one listening making no noise.”
3.2.4 How indexes promote over valuation:
“Indexes went from being price takers to essentially being the price maker. They are so big, whatever they do drives the market. You're taking away money from people who care about valuation and placing it into a structure that actually rewards overvaluation. Because if the stock is trading for twice what it's worth, when the money goes in the index fund, the index buys twice as much. What essentially happened was you had redemptions from undervalued stocks being redeployed into overvalued stocks.”
This comment relates to the value-weighted plumbing of the S&P 500 that I had covered in Part 1.
3.2.5 How few pay attention to how economics of the business and financials match:
“We are trying to figure out what businesses are worth, and we are trying to figure out the alignment of the decision-makers to make sure that the value is going to be maximized to the stakeholders. But we're no longer really focused that much on the differences between the economics of the business and what the financials say because I don't think anybody is paying any attention to this. It becomes sort of irrelevant.”
This comment is so depressing and partly explains why there is relatively little interest in financial markets to understand what is reported in financial statements. Because of such limited interest, rule making related to financial statements is increasingly dominated by the CFO and the audit community.
3.2.6 How active can make money:
“We used to be able to buy things and say, ‘Well, this is an okay company and it's at 11x earnings, but I think that the earnings are going to be 10% more over a year or two or maybe 20% more, and it will get re-rated then to 15x earnings because people will see that it's better than they thought, so the stock will go up 60% to 80% over a couple of years, then it will be fully appreciated and we'll move on to the next thing.’"
“The problem now is if you buy that thing, even if it plays out the way it does, if it started at 11x, earnings in two years, it's very likely, instead of being at 15x earnings, feels like it's going to be at 7x earnings. We’re basically at the same price with earnings up 40% over a couple of years. And you're not really going to make any money because there's nobody who is appreciating what is going on and analyzing it. It just gets lumped into a bucket.”
“So, we need to have that story combined with, well, instead of paying 11x earnings, we're going to pay 4x earnings. And we're going to pay 4x earnings, and there's going to be a 20% buyback going on. And I think if we're able to do that. And we can do that because there's really nobody paying attention, so there are plenty of companies that are actually that cheap.”
Einhorn is again lamenting the absence of “another side” that is supposed to correct market inefficiencies so that the original trader who spotted the inefficiency can actually get rewarded. Instead, the reward seems to rely more on getting part of your capital back through a stock buyback. We cannot expect much of an appreciation in the stock price of the under-valued company, contrary to what the textbooks say about how informational arbitrage is supposed to work! It is hard to know how much of this is because of index investing versus algorithmic trading of some other third factor.
In the end, let me share the reaction of someone pretty senior in the Big Three to my claim that the Grossman-Stiglitz paradox has become much worse post indexing: “prices are set all day in stock markets. Yet indexers only trade “on the close.” So, conceptually the price all day is being set by every type of investor except indexers. So how do you explain pricing during the rest of the trading day? You may say that people know that indexers will come in to trade on the close. But then you have to know if indexers received new money inbound, or have to pay our money, to their investors.”
My response would that be that predicting index related for stock is quite doable if one were to simply add the index weights of all the indexes that a firm is a part of, as disclosed by CAP IQ. Then, the “rational” expectation that the trader has in the back of her head kicks in regardless of whatever happens to the cash flows of the firm, within bounds, the index maker has to deploy the incoming funds into buying a certain portion of the stock. Think of the indexer’s role as a price support mechanism of sorts, via assured demand for the stock.
In part 3, I will conclude by looking at whether the Big Three actually have a disincentive to govern, why have shorts, activists and sell side analysts not filled the void and summarize a few takeaways.
