S&P Value is Growing
July 1, 2002
Why do stock prices jump when they're added to the list of Blue Chip companies whose shares make up the Standard & Poor's 500 Index? The answer is that the growing popularity of index membership since the mid-1980s has pumped up the price of S&P 500 stocks relative to stocks of other similar companies outside the index. It's an "indexing bubble," similar to the recent bubble in Internet stocks, that has economic consequences.
- S&P 500 stocks apparent overvaluation relative to comparable companies' increases is closely in step with the increase over time in index fund assets.
- For reasons not entirely clear, arbitrageurs don't correct this overvaluation by buying the stocks of the non-index companies that are undervalued by comparison.
- In response to the S&P premium, index funds could buy financial instruments known as derivatives to get the same index-tracking behavior of their shares as buying the actual stocks in the index (although this won't help if derivatives' issuers in turn hold index stocks to hedge their exposure).
- Or, companies within the index could issue more stocks to take advantage of the premium and use the money to buy productive assets or even whole firms not in the widely-followed indexes -- thus, indexing could cause economically inefficient over-investment by index member firms and economically inefficient merger and acquisition activity.
Another response would be for funds engaged in passive investment (buying and holding broadly diversified portfolios of stocks) to buy and hold a diversified portfolio of randomly selected stocks, rather than all funds investing in the same 500 stocks. That would have the "salubrious" effect of spreading passive demand for stocks across the market more evenly.
Source: David R. Francis, "Value of S & P Membership is Growing," NBER Digest, April 2002; based on Randall Morck and Fan Yang, "The Mysterious Growing Value of S&P Membership," NBER Working Paper No. 8654, National Bureau of Economic Research.
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