NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Value of S & P Membership is Growing

"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."

At cocktail parties, finance professors often are pressed for investment advice, and they typically recommend a well-diversified index fund. "This advice may have been far sounder than its propagators ever imagined," note NBER Research Associate Randall Morck and co-author Fan Yang.

Finance professors in general are aware of the "Efficient Markets Hypothesis," more popularly dubbed "the dartboard theory of investing." This theory holds that it is impossible to pick stocks that will perform better than average on a risk adjusted basis, unless an investor has inside information. This is because no publicly available information is useful in predicting stock returns. Stock investors, and there are millions of them, quickly act on any new information about a stock. So the market price of a share moves almost immediately and efficiently to an appropriate price. Thus, an investor might as well pick stocks by throwing darts at a list from the Wall Street Journal as go to the trouble of making a reasoned and calculated selection.

The optimal strategy, therefore, is to keep transactions and management costs low and to remain widely diversified. "Index funds generally accomplish these two goals better than other investment channels available to typical cocktail party guests," Morck and Yang write in The Mysterious Growing Value of S&P Membership (NBER Working Paper No. 8654).

In this paper, they attempt to solve the Wall Street mystery of why the price of a stock jumps when it is added to the list of Blue Chip companies whose shares make up the Standard & Poor's 500 Index. Their conclusion 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.

An alternative interpretation of the value premium of membership in the S&P 500 index is that Standard & Poor's analysts are able to pick stocks with mysterious intangible assets that justify abnormally high valuations. To test the two explanations, Morck and Yang compile a list of companies not in the S&P index but comparable to the S&P member companies. They look at the firms listed in Compustat (a Standard & Poor's service) for the years 1978 to 1997 and for companies in and out of the index, they calculate the average "Tobin's q ratio" -- this is the valuation of a firm by financial markets, reflected in the total value of its stocks, bonds, bank debt, and so on, divided by the replacement cost of the company. This measure, in effect, compares the values seen by financial markets and by accountants.

The authors find that the S&P 500 stocks appear overvalued relative to comparable companies, and that this apparent overvaluation increases closely in step with the increase over time in index fund assets. Of course, it could be that S&P analysts grew steadily better at selecting stocks with lasting premiums for its index precisely in line with the growth of indexing, but the authors argue that such a coincidence is unlikely.

For reasons not entirely clear, arbitrageurs do not correct this overvaluation by buying the stocks of the non-index companies that are undervalued by comparison. Also, the authors have yet to extend their analysis beyond 1997 when the bullish stock market subsequently became bearish.

In response to the S&P premium, the authors add, 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. 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.

-- David R. Francis


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