This is a summary of "The Economic Impact of Index Investing," by Jonathan Brogaard, Matthew C. Ringgenberg, and David Sovich, published in the Review of Financial Studies.
Based on the example of firms using index commodities, index investing in financial markets is shown to have real economic effects by reducing those firms’ profitability. This occurs because managers make worse capacity investment decisions as a result of poor commodity price information.
What Is the Investment Issue?
Aiming to assess a financial market effect on the real economy, the authors study the impact of index investing on firm performance. They quantify results from a market development that occurred around 2004 with a dramatic increase in the indexing of commodity futures termed “financialization.” Examining the link between this type of investment and businesses using the underlying commodities, the authors identify a negative externality from indexing. This is associated with an information effect of the feedback channel through which commodity-using firms learn from applicable prices.
In addition to having their production decisions misguided by distorted signals, firms are described as being exposed to input shocks from indexing. Increased financial flows into commodity indexes can influence the capacity investments of commodity users, with ultimate downstream consequences for output. Further, there is no evidence that financialization has simply led to a wealth transfer that benefits commodity producers (e.g., miners) over users (e.g., manufacturers).
How Did the Authors Conduct This Research?
The authors use data from Bloomberg, CRSP, Compustat, and the US SEC EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database for the 2000–07 period, described as a symmetrical window bracketing the 2004 financialization date. The sample has 21,000 firm-year observations—for which all firms have assets in excess of $10 million—with a difference-in-differences comparison between the treatment group (871 users of index commodities) and the control group (342 non-index users). These groups are distinguished by annual report content analysis counting the number of times exchange-listed commodities are mentioned.
The differences in financial performance between groups are posited to occur through two primary channels: budget constraint and feedback. Both indirect and direct channel tests determine that the feedback route is the locus of the financial effects. The authors confirm the findings via cross-sectional regressions on management use of commodity price information, with a comparison of commodity-using and commodity-producing firms ruling out financialization benefits to the latter. Finally, potential model biases that could incorrectly specify effects as due to firm decisions rather than investor trading are checked and ruled out.
What Are the Findings and Implications for Investors and Investment Professionals?
The authors estimate that after financialization, firms using index commodities experience a 6% increase in costs and a 40% decrease in operating profits. This overall degradation of financial performance is attributed to reduced commodity price informativeness as opposed to an adverse change in macroeconomic conditions, commodity supply/demand shocks, or commodity investors correctly anticipating such performance headwinds for firms. The noise induced by the future market participation of commodity traders and passive investors decreases firm managers’ sensitivity to price data as well as their efficiency in capital allocation. The one safeguard managers can implement is to expand their indicators of future commodity demand beyond market price signals, given that those with better information sources ex ante are less affected.
Conceivably, financialization can have analogous influences wherever derivatives are prominent, banking and financial services being a logical extension. In any case, beyond understanding commodity cycles, investors in firms converting physical resources should be attentive to the indirect effects of the full operating framework of those firms. As the authors note, “Index investing is not just a sideshow that transfers wealth and risk between investors: index investing affects the real economy.”
While the growing prevalence of index investing has definitely expanded diversification opportunities at lower management costs for financial investors, it has also drawn more critical scrutiny from academics assessing its potential downsides in the real economy (a leading example is José Azar, Martin C. Schmaltz, and Isabel Tecu, “Anticompetitive Effects of Common Ownership,” Journal of Finance 73, no. 4 [August 2018]: 1513–65). The authors of this study make no judgments about the overall economic welfare of indexing, but their research seems poised to be a ready reference for future grounds in that debate.