April 26, 2012
Indexing has been undergoing a boom. But is the steadily increasing volume of money that follows financial indices having some unintentional side-effects?
The more technical details of benchmark construction have historically been of interest only to a small group of industry insiders and financial academics. According to the authors of the four articles in this issue of the Journal of Indexes Europe, they merit much broader attention.
The recent move by FTSE to increase the minimum "free float" of its UK index series was a telling sign of the growing importance of indexing. The decision came in response to requests from a number of the firm's investor clients, who were apparently concerned about benchmark distortion. It's no secret that some companies whose activities are primarily outside Britain have been seeking to reincorporate in the UK under the relatively liberal rules of the local regulatory authorities. These currently permit the listing of shares by large companies that offer as little as 5% of their share capital for public trading. Lots of blind, index-following capital chasing a limited number of shares...you get the picture.
But while adjustment for free float has been standard practice at the world's major equity index providers for some time, there's still no accepted way of doing it. The two introductory articles to this issue, from FTSE's Chris Woods and Sebastian Seifried of Structured Solutions, present good summaries of the pros and cons in the float debate.
Konrad Sippel of STOXX also looks at pros and cons, this time in the context of the management of indices and the extent to which this process can be prescribed by a rulebook or left in the hands of an index committee. Again, the debate comes down to some points of considerable subtlety, but the compilers of index rules and those committee members have much more power over share prices (and markets) than many suppose.
And Jeff Wurgler, professor of finance at NYU, makes a direct reference to a famous essay by Keynes in the concluding article of this issue, on "the economic consequences of index-linked investing". Wurgler provides a cogent summary of the impact of indexing on share prices' comovements and their behaviour during periods of index rebalancing. He also examines the impact of passive investing on companies' valuations and on investor behaviour.
Indexing has rightly become established as a major investment innovation, writes Wurgler, but we shouldn't turn a blind eye to the potential market distortions that it might be causing. Our authors provide plenty of food for thought in this ongoing debate and I hope you will enjoy this issue.