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Dispatches

Size Factor Effect Present in S&P Index Funds

New flows of money into equity index funds have markedly different effects on the prices of assets than are theoretically implied by capital asset pricing modeling (CAPM).

by Matthew Bajkowski | February 2021

New flows of money into equity index funds have markedly different effects on the prices of assets than are theoretically implied by capital asset pricing modeling (CAPM).

Authors of a Centre for Economic Policy Research study found that new inflows disproportionately raised the prices of large-cap stocks in the S&P 500 index compared to those of small-cap stocks tracked by the index.

The disproportionality marked an overvaluation of high-weighted stocks and an undervaluation of low-weighted stocks in the S&P 500, showcasing an inefficient size factor in the markets.

Based on CAPM, the authors expected to find that new inflows would have a stronger price impact on stocks with higher price volatility, or beta, which are historically small, not large stocks.

The study used the flows of investor dollars into index mutual funds and exchange-traded funds (ETFs) that tracked the S&P 500 to examine the effects of the growth of passive investing by new investors over the last two decades. Almost half of all equity index mutual funds in 2019 tracked the S&P 500. The study found the distortion effect was confined to stocks within the S&P 500.

The disproportionately higher prices of large-cap stocks relative to the prices of small-cap stocks produced returns for portfolios of small-cap stocks that ran counter to those theoretically expected. Flows into index funds raised the concentration of index weights. The new flows into passive investing funds were associated with low returns for a portfolio of small index stocks but predicted a high future return for the same portfolios. This was due to the study finding that a stock’s weight in the S&P 500 is a strong negative predictor of its future return—meaning that future price return moves in the opposite direction of its weighting in the S&P 500.

The authors found that this backed up the idea of an S&P 500 size effect factor to stocks. Stocks in high demand by irrational noise traders were overvalued and accordingly entered weighted indexes with high weightings. Stocks in low demand were undervalued and entered with low weightings. Weighted funds taking in new investments exacerbated this disproportionality.

Source: “Tracking Biased Weights: Asset-Pricing Implications of Value-Weighted Indexing,” by Hao Jiang, Dimitri Vayanos, and Lu Zheng; Centre for Economic Research, December 2020.

Discussion

DONALD T from MI posted over 5 years ago:

I read the story and was like "so?" So I found a bloomberg story: https://www.bloomberg.com/news/articles/2021-01-13/trillions-of-dollars-in-index-funds-are-distorting-the-s-p-500 I felt better about things. Seems like an equal weighted s&p 500 fund might or might not do better for a period depending on if there is or is not a readjustment of the distortion in the s&p 500.


BILL N from MN posted over 5 years ago:

There are index funds which weight companies based on their valuation and other index funds which weight all S&P companies equally regardless of valuation. I have some of each, in addition to mid-cap and small-cap funds, and foreign asset funds. At any rate, each type of index fund, weighted or not, has advantages under different circumstances. Having assets in both types is just one more form of diversification.


DEAN S from AZ posted over 5 years ago:

Donald and Bill, great points and thanks for the link to the Bloomberg article. The crux seems to be: "The biggest question hanging over the latest research is if and how smaller companies can ever catch up." So it's a great question as to whether the smaller S&P companies eventually catch up based on rationality and the efficient market, or if the big cap bias has become a self fulfilling prophecy. My approach is similar to Bill's, with a good chunk invested in AAII strategies including the Shadow Stocks, I will probably stick with it for the time being. AAII, subject of a future webinar?


BARRY J from TX posted over 5 years ago:

Agree. Claude Shannon (the Bell Labs scientist who created information theory, and who was also a very, very successful investor) would classify this article as "noise," not "information." One of the AAII member benefits that I value highly is AAII articles that filter out the noise of the market. Markets are noisy by design. AAIII provides a huge advantage over the torrent of noise the "communication departments" of my brokers flood me with, most of which are ads for a technician who oversees a fund. I estimate that every AAII member shares my preference for high signal-to-noise ratios. To help you cut through the noise, I have noticed that recent low value, "noisy" articles come from NBER research. NBER is a great organization, but, even great organizations can lose focus. AAII should profit from the NBER example.


HOWARD F from MA posted over 5 years ago:

By how much?


J M from NJ posted over 5 years ago:

What happens in a down market? In an up market big cap stocks in the S & P 500 gain disproportionately. In a down market do the big cap stocks in the S & P 500 lose more proportionately?


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