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The impact of passive investing on corporate valuations

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  • Eric Belasco
  • Michael Finke
  • David Nanigian
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    Abstract

    Purpose – The purpose of this paper is to explore the impact of S&P 500 index fund money flow on the valuations of companies that are constituents of the index and those that are not. Design/methodology/approach – To examine the impact of passive investing on corporate valuations, the authors run panel regressions of price-to-earnings ratio on aggregate money flow into S&P 500 index funds and control for various accounting variables that impact price-to-earnings ratio. These regressions involve two samples of stocks. The first sample consists of S&P 500 constituents. The second consists of large-cap stocks that are not constituents of the S&P 500. The authors also run a set of separate regressions with price-to-book ratio rather than price-to-earnings ratio as the dependent variable. Findings – It is found that the valuations of S&P 500 constituents increased by 139 to 167 basis points relative to nonconstituents, depending on valuation metric, due to S&P 500 index fund money flow when evaluated at mean values of money flow and valuation metrics. The valuations of firms within the S&P 500 index respond positively to changes in S&P 500 index fund money flow while the valuations of firms outside the index do not. Additionally, the impact of money flow on valuations persists the month after the flow occurs, suggesting that the impact does not dissipate over time. Practical implications – Mispricings among individual stocks arising from index fund investing may reduce the allocative efficiency of the stock market and distort investors' performance evaluations of actively managed funds. Originality/value – The paper is the first to explore the long-run relationship between S&P 500 index fund money flow and corporate valuations.

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    File URL: http://www.emeraldinsight.com/journals.htm?issn=0307-4358&volume=38&issue=11&articleid=17053725&show=abstract
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    Bibliographic Info

    Article provided by Emerald Group Publishing in its journal Managerial Finance.

    Volume (Year): 38 (2012)
    Issue (Month): 11 (November)
    Pages: 1067-1084

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    Handle: RePEc:eme:mfipps:v:38:y:2012:i:11:p:1067-1084

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    Web page: http://www.emeraldinsight.com

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    Postal: Emerald Group Publishing, Howard House, Wagon Lane, Bingley, BD16 1WA, UK
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    Web: http://www.emeraldinsight.com/mf.htm

    Related research

    Keywords: Active management; Demand curves for stocks; Fund management; Index fund; Index premium; Indexing; Investments; Passive management; S&P 500;

    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
    2. Shleifer, Andrei, 1986. " Do Demand Curves for Stocks Slope Down?," Journal of Finance, American Finance Association, vol. 41(3), pages 579-90, July.
    3. Fama, Eugene F, 1970. "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, vol. 25(2), pages 383-417, May.
    4. Massimo Massa & William N. Goetzmann, 1998. "Index Funds and Stock Market Growth," Yale School of Management Working Papers ysm99, Yale School of Management.
    5. Gordon J. Alexander & Gjergji Cici & Scott Gibson, 2007. "Does Motivation Matter When Assessing Trade Performance? An Analysis of Mutual Funds," Review of Financial Studies, Society for Financial Studies, vol. 20(1), pages 125-150, January.
    6. Dimitri Vayanos & Denis Gromb, 2010. "Limits of Arbitrage: The State of the Theory," FMG Discussion Papers dp650, Financial Markets Group.
    7. Kenneth R. French, 2008. "Presidential Address: The Cost of Active Investing," Journal of Finance, American Finance Association, vol. 63(4), pages 1537-1573, 08.
    8. Yu, Fang (Frank), 2008. "Analyst coverage and earnings management," Journal of Financial Economics, Elsevier, vol. 88(2), pages 245-271, May.
    9. Petajisto, Antti, 2011. "The index premium and its hidden cost for index funds," Journal of Empirical Finance, Elsevier, vol. 18(2), pages 271-288, March.
    10. Jeffrey Wurgler, 2010. "On the Economic Consequences of Index-Linked Investing," NBER Working Papers 16376, National Bureau of Economic Research, Inc.
    11. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272.
    12. Denis Gromb & Dimitri Vayanos, 2010. "Limits of Arbitrage," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 251-275, December.
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