How index trading changed stock market investing

BOTHELL, Washington — Research by three University of Washington Bothell School of Business professors shows how the introduction of index funds changed stock market investing.

Their paper, “Evolutionary disruption of S&P 500 trading concentration: An intriguing tale of a financial innovation” was published March 24 in the open access journal PLOS ONE.

The authors are Associate Professor Gowri Shankar, Associate Professor James M. Miller and Professor P.V. (Sundar) Balakrishnan.

This paper is continuation of work that the authors started around the time of the 2007-09 Great Recession when they were studying changes in investor behavior.

The S&P 500 index is a list of 500 large firms that represent all sectors of the U.S. economy. It was introduced in 1957 to primarily function as a stock market indicator. In 1975, S&P 500 index funds were created. They allow investment in all 500 stocks that are in the index. Index funds soon became an attractive option to invest in the bundle of all 500 stocks.

After index funds were introduced, the concentration of trading volumes for the S&P 500 stocks decreased, the researchers found. This is in contrast to stocks that are not part of the S&P 500 index, for which the trading concentration steadily increased since 1960.

“In our 2008 paper published in Economics Letters, we adapted a statistical measure from the power law distribution to measure concentration in trading. We showed that daily trading volumes had steadily become more concentrated in the top decile and quintile of available firms,” said Balakrishnan. “This suggested that investors, perhaps overcome by the plethora of available choices and information, had increasingly narrowed their attention to a smaller set of large, well-known firms. We noticed this trend was consistent across the six decades we studied, suggesting an inexorable momentum and a natural evolution across many periods of stock market crisis.

“This finding is particularly relevant given the current pandemic gripping the world.”

Traditionally, investors pick stocks based on individual characteristics such as value, size, momentum or other factors. In an S&P 500 index fund, investors invest in all the stocks that are in the index. That is, investors trade all 500 stocks in proportion to their market value, without regard to the individual value or characteristics of any of these stocks.

“This index fund investing approach, first broached in the mid-1970s, was a dramatic change in investing philosophy and was very controversial when first proposed,” said Shankar. “Interest in S&P 500 and similar index funds has grown substantially over the years, with total investments in these funds currently exceeding $3.4 trillion.”

The authors examined how product bundling offered by the S&P 500 index fund affected the concentration of trading. They found that while the concentration of trading in stocks that are not part of the S&P 500 bundle continued to increase steadily from the 1960s to 2018, the concentration measure for trading in the S&P 500 stocks broke from the general market in the mid-1970s and has steadily become less concentrated.

The findings of this study have important implications for large parts of the asset management industry that focus on active portfolio management. If investors invest in stocks simply because they are in an index, it raises important questions about the future prospects for active portfolio management as well as security-level analysis used for price discovery.

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