Effect of index funds on stock markets

[Stephen Tashi]

The article https://www.bloomberg.com/news/feat...dden-dangers-of-the-great-index-fund-takeover points out that 3 large index funds hold significant voting power in many US corporations and discusses possible effects ("dangers") that can arise from this.

Another question, that I haven't seen discussed, is: What is the behavior of a stock market where a large share of stocks are held by participants who passively track the prices set by other participants? We could add to that the fact that (in the US market) a large share of the active participants are computers executing various trading algorithms. Have their been any academic studies that model such a market?

 

[fresh_42]

... where a large share of stocks are held by participants who passively track the prices set by other participants?

I don't think that this exists. Who would hold a large share and would not track price development? Fund managers do for certain, and almost all those have an ongoing stop loss order. And they are regularly contacted by their brokers, so there is a daily dialogue. Large shares in the hand of a majority owner might be a different subject, as they probably have different goals.

The question in the title should be the other way around: Effect of index funds on specific stocks. This is a more direct dependency than to the entire market, especially if companies drop out or are put in. Then all of a sudden large quantities of stocks have to be sold and bought, and that directly affects the prices. I can't think of significant other effects, because index funds follow per definition the market, so they are forced to map market developments.

Have there been any academic studies that model such a market?

I guess it will be difficult to find a (reasonable) question to which there are no studies.

 

[Stephen Tashi]

I don't think that this exists. Who would hold a large share and would not track price development? Fund managers do for certain, and almost all those have an ongoing stop loss order. And they are regularly contacted by their brokers, so there is a daily dialogue.

I don't know the exact mechanics of managing an index fund, but what you describe doesn't sound like an index fund.

Are you saying that index funds don't passively track stock prices? - or do you say that index funds do passively track prices but are not large shareholders in the total market?

 

[fresh_42]

I first answered to your large shareholder description which had nothing to do with an index fund. No wonder it doesn't sound as an answer to index funds.

I say that index funds are put together in the same way the index is. So they have only to change their portfolio if the index is changed. This doesn't happen very often, so once they are set up, they stay for a while, regardless of the prices. However, market capitalisation changes a lot, so they have to (passively) react accordingly. Prices are meaningless for index funds, as long as there are no additional agreements.

 

[Vanadium 50]

There seems to be this idea that an index fund is exactly the mix of stocks that makes up the index. It's not - it's a basket of stocks intended to track the index. This is not perfect, and the difference between the index and the fund is called the "tracking error". You can see how a fund manager who held a little too much #499 and not quite enough #500 might not want to spend the commission to "fix this". There are 505 (not a typo) stocks in the S&P 500 and the Vanguard VOO fund holds 509 of them.

 

[pbuk]

Another question, that I haven't seen discussed, is: What is the behavior of a stock market where a large share of stocks are held by participants who passively track the prices set by other participants? We could add to that the fact that (in the US market) a large share of the active participants are computers executing various trading algorithms. Have their been any academic studies that model such a market?

Yes lots, as well as some real-world examples of failure, see for instance https://blogs.lse.ac.uk/businessrev...-the-era-of-algorithms-and-automated-trading/

Edit: this wasn't an index tracker issue but the point regarding self-realising automated trade criteria is possibly relevant.

 

[Vanadium 50]

So they have only to change their portfolio if the index is changed.

Or a divided is paid. In the "PF2" index, there are two stocks, ABC at $100 and DEF also at $100. ABC pays a $10 dividend, and now ABC is at $90. And the fund manager now has $10 he needs to do something with (which is to buy $4.73 worth of ABC and $5.26 worth of DEF).

 

[fresh_42]

Or a divided is paid. In the "PF2" index, there are two stocks, ABC at $100 and DEF also at $100. ABC pays a $10 dividend, and now ABC is at $90. And the fund manager now has $10 he needs to do something with (which is to buy $4.73 worth of ABC and $5.26 worth of DEF).

Yes, market capitalisation changes a lot: re buys, capital increases, and then the additional capital from dividends. But compared with an exchange in the portfolio, these are marginal sums. E.g. our major market index has only 30 papers and if a heavy weight like LH drops out due to the current crises, then big money was moved.