How Index Funds Distort Markets

As index funds gain in popularity, there are signs that they're affecting stock prices. In some cases, investors may be better served by investing in actively managed funds.
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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) - Get Report

, 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.

So far, trading has caused smaller distortions in foreign and large-cap benchmarks. But the impact of index funds is troubling. Stocks routinely spike when they are added to the S&P 500. After S&P announced that it would add

Google

(GOOG) - Get Report

to its benchmark, the shares immediately soared 8%.

Besides distorting prices of individual shares, the benchmarks may contribute to bubbles that have swept the markets repeatedly. This is because most benchmarks are weighted by market capitalization. That means big stocks have more weight in an index than small ones. For example,

Exxon Mobil

(XOM) - Get Report

is the biggest stock in the S&P 500 and accounts for 3.0% of the assets in the benchmark.

The New York Times

(NYT) - Get Report

is one of the smallest stocks in the index, accounting for only 0.01%. When oil prices rise, shares of Exxon Mobil account for a bigger percentage of the index, so shareholders who put cash in the fund are buying more and more oil shares.

The use of market capitalization can hurt the returns of index funds, argues Jason Hsu, chief investment officer of Research Affiliates. "In an S&P 500 fund, the more overvalued a stock becomes, the more assets will go into it," he says.

The impact of overweighting became clear in the late 1980s when Japanese stocks were soaring and came to account for about 65% of the Morgan Stanley Capital International EAFE index, a market-weighted benchmark. Investors who tracked the index were pouring money into overpriced stocks that were about to crash. Today Japanese stocks account for about 20% of the benchmark and remain well below the all-time highs that were recorded two decades ago.

In the late 1990s, another bubble appeared when technology stocks climbed. Investors who bought index funds that tracked the

Nasdaq 100

were making heavy bets on stocks such as

Amazon

(AMZN) - Get Report

and

eBay

(EBAY) - Get Report

. The benchmark fell off a cliff and has never come close to reaching its former highs.

More recently, S&P 500 funds soared and fell along with financial stocks. That last collapse helps to explain why

Vanguard 500 Index

(VFINX) - Get Report

, the oldest S&P 500 fund, has lost about 1% annually for the past decade, trailing 57% of large blend funds.

In an era when index funds are distorting markets, should you own passive or active funds? Many academics argue that index funds are superior to active management in all environments. Because index funds have lower fees, they tend to outperform most active funds over long periods, the researchers say.

Cheap index funds are clearly preferable to poor active funds, says Bridget Macaskill, CEO of First Eagle Investment Management. But when the S&P 500 dropped 37% in 2008, index investors were not consoled by the fact that they may have saved a percentage point in fees. Macaskill says that instead of relying on index funds, most investors would be better served by active funds that are designed to limit risk. "Investors do not want to suffer a permanent loss of capital," she says. "If your primary goal is to avoid losses, then index funds are not the way to go."

Macaskill says that the cautious funds sold by her company have protected capital while delivering strong long-term returns. In 2008,

First Eagle US Value

(FEVAX) - Get Report

lost 23% and outdid the S&P 500 by 13 percentage points. Other funds that excelled in the downturn include

First Eagle Global

(SGENX) - Get Report

and

First Eagle Overseas

(SGOVX) - Get Report

. The three funds have all outperformed their categories by wide margins during the past five years.

First Eagle has limited risk by focusing on solid companies that are undervalued compared to their assets and cash flows. The funds stay broadly diversified and sometimes hold bonds or gold for insurance. That has proven to be a recipe for success in an era of difficult markets.

-- Reported by Stan Luxenberg in New York.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.