The Ease of Index Funds Comes With Risk
From: nytimes.com
The logic of investing in index funds has so far seemed simple and compelling for growing numbers of people.
Why spend the time researching individual securities and run the risk of choosing the wrong stock in the wrong sector when you can simply buy the market as a whole? Put your money in an exchange-traded fund, or E.T.F., or in a traditional mutual fund that passively tracks a stock index like the Standard & Poor’s 500 or the Russell 2000 and you have instant diversification without the risk of error in security analysis. The fees for such funds are typically very low, too. And E.T.F.s are traded all day, making for easy entry and exit.
But if you look closely at such funds, as several scholars and analysts have done, you may find that their simplicity harbors some simmering problems, which have grown more troubling in the course of the bull market in stocks.
Stocks in the Russell 2000 seem especially bloated in valuation when compared with non-index peers. S&P Capital IQ compared the valuation of stocks within that index to stocks of similar market capitalization that are not in the index. It used a common valuation metric, the ratio of stock price-to-book value. It found that the valuation gap between stocks in the index, and those outside it, had swollen enormously. That could make investing in the index a riskier proposition than is widely understood.
Nonetheless, the popularity of index-tracking funds is unquestionable. They now account for over 30 percent of all stock and bond mutual fund and exchange-traded fund assets under management, according to Morningstar.
But cracks in the edifice of passive investing are beginning to show. While investing in index funds may still make a good deal of sense, it’s important to understand some of the funds’ pitfalls.
The August downturn, for example, featured multiple E.T.F. trading halts that suggested the funds are not easy to get out of in periods of high volatility. For the month as a whole, index stocks, especially those in the Russell 2000, also sold off a bit more sharply than non-index stocks, notes James Xiong, head of quantitative research at Morningstar. And both during and before the correction, index stocks moved together with a high enough correlation to call diversification claims into question.
Most disturbing, though, is the increasingly distorted levels of the valuations of some of the largest index funds. The combination of a long-toothed bull market and the significant shift to passive investing has indiscriminately buoyed all stocks in major indexes like the S.&P. 500 and the Russell 2000. Stocks that might not be bought singly on their own merits have been lifted by the package buying. Some portfolio managers, academics and market trackers now contend that the soaring of the mediocre alongside the exceptional has produced unusually elevated valuations.
The existence of a valuation premium for stocks newly included in index funds has long been known, of course. On average, from 1990 to 2005, when a stock was added to the S.&P. 500 — effectively requiring many investors to hold the stock for the first time — the mere inclusion added almost 9 percent to share prices, according to Jeffrey Wurgler, a professor of finance at New York University.
And it’s possible that, to some degree at least, stocks that are included in index funds are chosen precisely because their prospects are better and they deserve a higher valuation. In addition, another factor behind the current high valuations of stocks in the indexes is that investors have generally favored large-cap stocks in the current bull market, and the S.&P. 500 and Russell 2000 track such stocks.
Even so, current valuations for stocks in the S.&P. 500 and Russell 2000 have soared well beyond what might otherwise be expected, some analysts and portfolio managers say.
According to the calculations of S&P Capital IQ, non-Russell 2000 index stocks carry a median price-to-book value ratio of 1.34. But index stocks are accorded a 61.9 percent valuation premium at 2.16 price-to-book as of June 30. The premium has been in place each of the last 10 years but has been rising. In 2006, for example, it was just 12 percent.
“There’s no doubt in my mind that passive investing in E.T.F.s and index funds inflates the price of index stocks versus non-index stocks,” said Brian Frank, who manages the Frank Value mutual fund. “The whole market is overvalued,” he added. “Index stocks are more overvalued.”
Randall Morck, a business professor at the University of Alberta, has also concluded that stocks with the good fortune to be included in a major index receive premium valuation over those that are left out. Professor Morck is gathering data on current index valuations. He has tracked stock valuations through 2009. “It appears that the index premium rises as the market becomes more overvalued,” he said.
Professor Wurgler has also researched index premiums. “The evidence says that stock prices increasingly depend not just on fundamentals but also on the happenstance of index membership,” he said.
