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ETFs and passive investing severely skewed S&P 500 valuations

Scientists are beginning to come to the conclusion that we’ve been talking about for years: ETF inflow and passive investing in today’s market can be more of a problem than it seems. Many people currently believe that the largest companies are in a bubble and that it is worth looking for small-cap companies in 2021. New research supports this claim. In fact, passive flows in the S&P 500 “disproportionately inflated the prices of its largest participants, paving the way for small benchmarking companies to eventually outperform them,” according to a new BNN report.

The report, cited by a team from Michigan State University, the London School of Economics and the University of California, Irvine, analyzed data from 2000 to 2019. The authors of this report are Hao Jiang, Dimitri Wayanos, and Lu Zheng. The conclusion was that the smaller members of the S&P 500 are getting too cheap compared to the larger names. “Flows to funds that track the S&P 500 are disproportionately raising the prices of large-cap stocks in the index relative to the prices of small stocks in the index. These flows predict high future returns for a portfolio of small minus large indices, ”the document says.
The study found that “noise traders” (passive investors) “tend to raise the prices of trendy big companies when they enter the S&P 500.” This forces these companies to carry a higher profile, which creates a self-fulfilling prophecy when new passive traders enter the market. The document notes: “When prices are distorted, the weights of the value-weighted indexes are biased and flows to index funds exacerbate the distortion.” This obviously means that when returning to the mean, smaller-cap stocks will perform better. The study says the S&P 500 will eventually normalize. In fact, this suggests that a portfolio that opens up long positions for the smallest companies in the S&P, while short for the larger ones, can return an average of 10% per annum.

“If index-related price distortions become more significant over time, they can increase the profitability of active investment strategies that take advantage of these distortions and ultimately slow down the transition to passive investing,” the article concludes.

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