How Index Funds Distort Markets

NEW YORK (TheStreet) -- Investors have been pouring into index funds. Of the $3.2 trillion in domestic stock funds, 19% is in passive portfolios, according to Morningstar. That is up from 15% five years ago.

The amount of passive assets is larger than the data suggest, however. Many funds that claim to be actively managed are actually closet indexers, closely tracking the S&P 500 or some other benchmark.

What happens if the trend toward indexing continues? At some point the markets would cease to function. If too many people pick the same stocks on the same day, then prices will be distorted.

Although index funds do not yet dominate the markets, there are some signs that passive funds already are affecting stock prices. Some of the biggest distortions have occurred among stocks that track the Russell 2000, a small-cap benchmark. The problems are connected to the way that Russell designs the index.

Each June, Russell reconstitutes its benchmarks. The company calculates the 3000 largest stocks based on market capitalization. The 1000 largest go into the Russell 1000 and the next 2000 become the Russell 2000. Whenever a company enters the Russell 2000, the share price typically rises because many index funds must buy the stock. Anticipating the bounce that stocks will receive, hedge funds and other speculators compile lists of candidates that are likely to enter the Russell 2000. The speculators buy the stocks ahead of time and enjoy reliable gains.

As the number of speculators increased, the prices of entering stocks became more inflated. The speculators also began selling stocks departing the benchmark. That depressed shares.

Because of all the trading, stocks enter the Russell index at high prices and leave it at discounts. That depresses the returns of the benchmark by 1.5% to 2% a year, estimates Peter Jankovskis, co-chief investment officer of Oakbrook Investments, an investment advisory firm in Lisle, Ill. "It has become easier for active managers to beat the small-cap benchmark," says Jankovskis.

To appreciate the impact of market distortions on index fund investors, consider BlackRock Small Cap Index(MASKX), which tracks the Russell benchmark. The fund returned 4.3% annually during the past 10 years, lagging 80% of competitors and underperforming the average small blend fund by 1.5 percentage points.