Index-Linked Investing: The Economic Impact

Evidence shows indices are generating new stock market phenomena.

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number tape(From SSRN) A market index summarizes the performance of a group of securities into one number. The use of stock market indices in particular has been growing exponentially for years. Since Charles Dow introduced his indices in 1884, the number of distinct stock market indices reported in the Wall Street Journal has increased roughly five percent per year, as shown in Figure 1. Today’s Journal reports not just the DJIA and the S&P 500. It also reports on the Turkey Titans 20 and the Philadelphia Stock Exchange Oil Service Index. Markets are being tracked in more and more detail, and the figure suggests there is no end in sight.

The proliferation of indices reflects their ever-growing importance to the investment industry. Trillions of dollars are managed with some connection to an index, with the S&P500 and MSCI World being among the most popular equity indices. Institutional investors often ask a fund manager to beat a particular index. Individuals may wish to match one via an index fund. Hedgers, speculators, and fund managers may manage exposure to index members through index derivatives. While this article focuses on stock markets, indices and associated investment products have proliferated also in debt markets, commodities, currencies, and other asset classes.

It is time to reflect on the broader economic consequences of these trends. I define index-linked investing as investing that focuses on a predefined and publicly-known set of stocks. In this article, I review some evidence that indices are no longer mere carriers of information, but that they and their associated index-linked investing strategies have become so popular that they are generating new stock market phenomena in their own right. Because so many economic decisions are tied to stock prices, these phenomena affect the real economy. But for sake of balance, it is important to start by acknowledging the many considerable benefits that indices and index-linked investment products provide. They allow managers and investors to calculate “betas” for cost of capital calculations, and to learn from the information that indices contain about investment opportunities. Policymakers use indices as forward-looking indicators of economic conditions. And, most obviously, investors have greatly benefited from these innovations. Index funds generally have lower expenses and costs than actively managed funds. They provide exposure to specific diversified portfolios, including portfolios of international stocks that would otherwise be difficult to construct and, for those delegating investment management, to monitor. Their core strategy tends to minimize distributions and thus is relatively tax efficient.

There is no doubt that indices and associated investment products are innovations that on the whole have benefited many individuals and institutions. On the other hand, their popularity has created underappreciated side effects. As I discuss below, these all stem from the finite ability of stock markets to absorb index-shaped demands for stocks. Not unlike the life cycles of some other major financial innovations, the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits while at the same time increasing its broader economic costs. Read the full paper.

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