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I can't help but notice the popularity of index mutual funds over actively managed funds. I think all the arguments are sound, but I have one worry:

Index funds are run by buying the stocks listed in a particular index, with the goal being to get the fund performance to track the index performance. Now if all this money starts pouring into index mutual funds, doesn't that mean that the demand for stocks that are listed on an index will go up, but the demand for stocks not listed will be stagnant (or drop due to money being moved from actively managed funds)?

Will this not create a pricing bubble for these stocks? If I'm holding index mutual funds because they're popular, won't I see a big drop in value when the "smart money" pulls out?

Edit

One possible answer to this, from a technical sense, would be to point out that the amount of money in index funds is much, much less than the total money invested in those stocks (like 1/1000th) and so any price inflation would be tiny. However, I don't know how you'd dig up that information.

Edit 2

There is evidence that even being included in an index will affect a stock's price, as will de-listing it:

Papers investigating Standard and Poor’s 500 Stock Index (S&P 500) composition changes over the 1976–88 period find a change-day positive (negative) abnormal return of approximately 3% (1.5%) for additions (deletions).

Also, from here:

Many mutual funds and exchange-traded funds (ETFs) are based on various stock indices. When an index is rebalanced, the funds must sell the deleted stocks and buy the added ones in their portfolios. Fund buying often causes short-term volume and price spikes in the newly-added stocks. After the flurry of buying activity generated by index rebalancing, the stocks go back to trading based on their fundamentals. However, investor inflows into mutual funds and ETFs can push up the prices of all stocks in an index, in the same way that investor outflows can push them down.

An index may announce changes to its composition ahead of time. For example: On the 15th of the month an index publishes stock deletions and additions effective on the 1st of the following month. Index funds cannot make any changes to their portfolios until the index is officially changed, but speculators may start buying the new additions right away, reasoning that the funds will have to buy them later at any price. Speculator front running can cause the prices of stocks being added to increase prior to the official rebalancing date.

(emphasis mine)

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Why was this down voted? Isn't recognition of a bubble in a market a pretty important item? –  MrChrister Aug 2 '12 at 23:42
    
Do you have a prospectus for a S&P 500 index fund that says it holds only a subset of the 500 stocks comprising the index? I know that total market index funds hold only a subset of the total stocks on the market (and say so up front in the prospectus), but didn't know of a S&P 500 index fund that did the same. –  Dilip Sarwate Aug 2 '12 at 23:49
    
@DilipSarwate - no, I'm not certain. I do know that some index funds, for an index that has thousands of stocks, don't necessarily buy all of them, but get a subset. I don't think that bears on the relevance of the question though. –  Scott Whitlock Aug 3 '12 at 0:04
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I think this is an interesting enough question. It may affect whether a personal investor believes they should invest in indexed mutual funds or should invest in, say, stocks which just didn't quite make the cut for some influential index. –  ChrisInEdmonton Aug 3 '12 at 1:19
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@ChrisInEdmonton But I am down-voting this question because it is based on faulty premises and cannot be answered reasonably until the question is edited to be more accurate in what it claims to be facts. –  Dilip Sarwate Aug 3 '12 at 1:28

1 Answer 1

up vote 10 down vote accepted

With regard to commodity futures, a paper released in January 2010 by Aulerich, Irwin, and Garcia, concluded that index funds have essentially no impact on commodity futures.

Looking at stocks, a stock that gets included in a major index does increase in price. It increases its turnover by 27% and increases its price by between 2.7% and 5.5%, according to information cited by Kula in this paper, though it looks like the price increase tends to happen in the lead up to the stock being included.

Interestingly, I have read an article but cannot now locate it, which states that there's a measurable, albeit fairly small, price bubble on stocks included in common indexes, on Monday mornings, Friday afternoons, and at the start and end of the month. That is, the times when mutual funds are most likely to rebalance their holdings. This almost certainly applies to a lesser extent to other stocks, too. My understanding is that the price difference was very small, however.

Generally speaking, stocks which make part of well-known indexes will tend to be in higher demand than stocks which do not. It remains the case that almost all actively-managed mutual funds are unable to consistently beat the indexes, even with this taken into account.

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