A long-standing theory suggests that the market will become more inefficient as more money gets indexed. You’re welcome to argue the validity of if/when that might happen. I believe it’s possible but unlikely to happen on a grand scale anytime soon. But I also believe index funds create pockets of inefficiency that nimble investors can pick at.
The opportunities are due to changes in the underlying index and the reaction by index funds to keep up. Seth Klarman refers to it as mindless selling:
Think about an index fund. If a stock is in an index, something like 10% of the market has to own it, because that’s how much the indexing activity is in the U.S. for say the S&P. If the stock gets kicked out of the S&P 500, 10% of the company has to be sold.
Indexes, like the S&P 500, add and remove stocks all the time. In the case of the S&P 500, it amounts to about 4% of the index per year on average. That turnover creates opportunities as index funds buy and sell stocks to stay consistent with the index.
The simplified version goes like this: the prices of stocks being added to the index tend to get bid higher, while the stocks being dropped see their prices fall. In both cases, stocks are being bought and sold regardless of price. But it’s a bit more complicated than that.
Recent research by Michael Mauboussin attempted to quantify the impact of the turnover. Essentially they studied the track record of the S&P 500 committee’s decisions to add and remove stocks. Two points stood out: the committee suffers from the same behavioral errors as the average investors and the opportunities around mindless selling exists.
The study compares stock performance before being added and after being removed from the S&P 500 over a 1 and 3 year period. The excerpt below covers their findings (note TSR stands for Total Shareholder Return):
The companies the committee removed had three-year returns that lagged the S&P 500 and one-year returns that were essentially equal to the index. Naturally, the TSRs reflect the reason the committee had to drop a company. (See exhibit 8.) For example, the companies that left as the result of M&A had average relative returns of 3 percent per year for three years and 27 percent for one year.
Companies that failed fared poorly prior to exclusion. Those companies had average relative TSRs of -31 percent per year for three years and -40 percent for one year. Companies that left the index for other reasons had returns roughly in line with that of the S&P 500. For each type, the median returns prior to removal are similar to those for the mean. Companies that were acquired had excellent relative TSRs, those that failed had poor TSRs, and the other companies performed about in line with the market.
However, the past is not prologue…the average TSRs over the following year the companies the committee removed but that continued to trade trounced those of the companies the committee added. One year after a change, the average relative TSR for the companies the committee added was -2 percent while the relative TSR for the companies removed was 27 percent. Despite the sharp divergence in the first year, the disparity does contract over three years. These results are consistent with prior research examining changes to the S&P 500 and Dow Jones Industrial Average. The S&P 500 Index committee buys high and sells low.
For active investors the opportunity is obvious. The data shows the real opportunity is in the first year. After that, the outperformance drops off.
Still, context matters.
A 4% turnover amounts to about 20 changes per year, but it’s inconsistent at best nor does each change equate to an opportunity. M&A was the biggest reason for removal. As companies are bought, the stock no longer trades on the market, so the S&P committee has no choice but to replace the stock. In that regard, the opportunity might persist only because it doesn’t happen often enough to pay attention to it. At best, you can add it to your list of places to look for mispriced stocks.
The real opportunity might be around stocks being added by the S&P committee. Active investors owning any stock being added to the S&P 500 might want to take notice since those stocks tend to underperform the index.
For index investors, you should know what’s going on underneath it all. Index funds track indexes that change over time. The people making those decisions are as guilty of buying high and selling low as the next person. Arguably, the rules used to qualify additions and removals reinforce those mistakes. So be aware of it, just don’t freak out about it. The pros of index funds still outweigh the cons in this case.