Is the growing demand for index funds artificially inflating equity prices, or is it providing additional liquidity and aiding price discovery?
Earnings lag: As equity indexes move toward new highs, earnings haven't kept pace as forces other than fundamentals drive equity market gains. While the low-rate environment has boosted values, the greater interest in passive investments has also elevated prices.
Passive growth: Assets invested in passive equity neared $4.5 trillion as of June 30 and have more than doubled since 2010. Over that period, equity trading volume has been more erratic, but has grown steadily since 2013.
More turnover: Bid/ask spreads among S&P 500 shares have been on the rise. However, with annual turnover of related index funds only about 6.6%, these funds are not providing material liquidity to the market. Small-cap index funds turn over about 4x more, while spreads have increased at a more dramatic rate; if they are providing liquidity, it's coming at added cost.
Growing influence: Passive assets are about a fifth of all U.S. equity assets. Active, alternative beta funds and equity hedge funds temper the impact of the growing influence of index funds on the market by adding liquidity through their strategies and short selling.
Sources: P&I Research Center; Bloomberg LP; SIFMA; Investment Technology Group
Compiled and designed by Charles McGrath and Gregg A. Runburg