ETFs – More findings from the research

Continuing my yesterday’s post on ETFs – their impact on your investments?, the research paper of Jefrey Wurgler, Nomura Professor of Finance, NYU Stern School of Business “On the Economic Consequences of Index-linked Investing” has other findings which I would like to highlight in this post.

On ETFs he says that 

“…the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits while at the same time increasing its broader economic costs.” 

One can estimate the size of such funds from the following. 

“Standard & Poor’s reports that as of this writing (July 2010) there is $3.5 trillion benchmarked to the S&P 500 alone, including $915 billion in explicit Index funds. ETFs now amount to $1 trillion across all asset classes and indices. Russell estimates that $3.9 trillion is currently benchmarked to its indices. This gets us quickly to about $8 trillion in easily countable products.”

No doubt as ETFs continued to get popular in countries like India, they will start making impact on index stocks and their returns.

It further states that the stock which gets included in the Index changes its return pattern 'magically' and 'quickly'.  It begins to move closely with its other constituent stocks and less closely with the rest of the market.  In statistical terms, its co-variance increases with index stocks, thus increasing its beta.  This affects various corporate investment and financing decisions taken by this particular company (Remember Capital Asset Pricing Model (CAPM) where beta of the stock is one of the inputs for calculation of Cost of Equity).

Another interesting finding of its impact on the performance of active fund managers.
  

“the popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average, to beat the index – it may actually be contributing to their underperformance."

Finally ending with his conclusion

"Indices and index-based investing are innovations that are here to stay and have rightly become central to modern investing.  The consequences are here to stay as well.  Research on the magnitude of the economic distortions they cause is needed, as are suggestions how regulators and market structures might reduce them."