In this segment, I argue that passive index creates index zombies that survive because of relatively guaranteed demand for their stock from indexers. I also hypothesize that indexing reduces the production of value relevant information to price stocks by active investors.
3.0 How much of a social cost does indexing impose?
What is good for individual investors like me you and me may not be as good for the system. My thesis is that index investing creates a disconnect between the providers of capital (you and me via 401ks and other investment accounts) and the CEO or the CFO of the firm which “gets” this capital. I have written about whether anyone has really met the real “shareholder” (you and me not the Big Three) when corporate managements talk about shareholder value. This is not to say that we don’t have retail investors who still buy individual stocks, but most of the stock held by individuals is via indexes in their defined contribution (401k) plans.
3.1 Index zombies do not have to fight for capital
The biggest cost of passive indexing might entail subsidizing firms who do not have to fight for capital as being in the index guarantees demand for their shares without having to work very hard for it. Absent such demand, share prices of these zombies would have fallen faster than in a counterfactual world without such rampant indexing.
A textbook example of such a subsidy is IBM in the S&P 500 index. IBM has underperformed the S&P 500 by around 80% over the last 10 years. Yet, the top three owners, BlackRock, Vanguard, and SSGA, continue to collectively own around 25% of the company and its not obvious what they have done to get IBM management to address such underperformance. You could argue that ultimately, fundamentals will have to catch up with weak companies. Yes, and no. If a firm keeps losing cash flow, eventually its market capitalization shrinks, and it gets thrown out of the S&P 500 perhaps only to migrate to the S&P 600 mid-cap world. However, if the firm generates stable cash flows like IBM without much growth in revenue, it can stay an “index zombie” for a long time.
Of course, you could argue that not every company must keep growing by leaps and bounds. There are plenty of active value investors who love steady-eddy companies with stable cashflows such as utilities. Of course, my point is simply that in a counterfactual world with not as much rampant indexing, such zombies would have far lower valuations and hence lower market to book or price-earnings ratios.
In a world without passive indexing, bad news about absence of revenue growth at IBM might have been priced in more rapidly. Hence, IBM’s stock might have under-performed by even more than 80% which, in turn, might have forced the board and management to take its bitter medicine much earlier. IBM is not the only index zombie. I have not run the numbers (in progress for a research project) but airlines such as Delta, and American or retailers that have been “Amazoned” away such as Nordstrom and Macy’s would perhaps have restructured their businesses earlier, had they not been part of the S&P 500. But this argument, by itself, creates an opening for activists such as Elliot to flourish. We will come back to that later.
The flip side of this problem is over-valuation. A textbook example is the introduction of Tesla to the S&P 500. During the summer of 2020, after Tesla had reported four consecutive quarters of profit, the S&P Dow Jones Committee decided to add Tesla in November 2020 to the S&P 500. That decision triggered frenzied buying and ended up raising Tesla’s market capitalization from around $100 billion to $650 billion!
Tesla’s equity, as of May 3, 2023, was worth $508 billion. How does that compare with its 10 closest competitors? BYD, the Chinese EV maker, was worth $99 billion, followed by Mercedes-Benz group for $83 billion, BMW at $72 billion, Ford at $47 billion, GM at $46 billion, Honda at $44 billion, Hyundai at $35 billion, Kia at $26 billion and Renault at $9 billion. That is, Tesla is worth more than its 10 competitors combined ($461 billion).
You could come back and ask, “How do you explain the decline in Tesla’s stock price more recently, since they are still in the S&P 500?” Well, the calculations of market caps of competitors that I went over is based on today’s valuations. And my argument is not that an indexed firm will never experience stock price declines. I simply suggest that prominent index members will be overvalued with rampant indexing.
A skeptic can also ask, “Why are the bulk of the S&P returns this year…
Read More: What Are We Paying Indexers For Being Passive? Part 2