The impact of passive investing on corporate valuations

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.

Citation

Belasco, E., Finke, M. and Nanigian, D. (2012), "The impact of passive investing on corporate valuations", Managerial Finance, Vol. 38 No. 11, pp. 1067-1084. https://doi.org/10.1108/03074351211266793