Style-related Comovement: Fundamentals or Labels?
Authors: Brian H. Boyer
Source: Journal of Finance, vol. 66, n°1
Date: February 2011
Financial institutions tend to gather assets sharing similar characteristics in a reduced number of categories, to make it easier for investors to allocate their funds. Thus, investors can allocate their portfolios based on asset style, rather than investigating individual assets. However, the style segregation rules can be somewhat arbitrary and some assets may be transferred from one group to another, even if fundamental values do not justify it. Using S&P/Barra style indices, the author analyses the effect on asset returns of asset transfer from one style index to another. Lots of market players, including index fund managers, exchange-traded fund (ETF) managers, and possibly active fund managers using an index as benchmark, base their investment on style indices. As a result, any asset movement, from one index to another, causes massive trading on this asset from those managers.
The S&P/Barra Value and Growth indices are set up based on asset book-to-market (BM) ratio, and so that the two indices have equal market cap. As a result, as soon as one of the two indices outperforms the other, the indices have to be rebalanced to keep the same market cap for the two indices. This may cause assets to change indices even though their BM ratio did not move in the expected way. For example, an asset with a decreasing BM ratio may switch from the Value index to the Growth index. The question is then to know if those assets, designated “index balancers” by the author, will be more correlated with the index they left or the index they join. Empirical investigations have been performed using data available from May 1981 to December 2004. The S&P/Barra style indices were launched in May 1992, but the indices were backdating to May 1981.
Using daily data, Boyer regressed index balancer returns on the returns of Value and Growth indices over the 1992-2004 period. The results show that these assets exhibit on average an increase in their covariance with the index they join, while on average their covariance with the other index decreases. These results are even stronger during the 1998-2002 period, a period during which indices encountered particularly high turnover. Conversely, the results obtained over the 1981-1992 period, i.e. before the S&P/Barra style index introduction, show no evidence to reject the fundamental hypothesis, namely a higher covariance with the index left and a lower covariance with the index joined. In addition, the author sought to identify to what extent investors base their fund allocation on the index label. His observations suggest they do – especially mutual fund managers – even though the underlying fundamentals of the assets those indices are made up of may differ from the label exhibited.
The present work can be related to other papers studying the effect of index inclusion on assets. Vijh (1994), Barberis, Shleifer, and Wurgler (2005), Denis et al. (2003) dealt with asset inclusion in the S&P 500. However, the present work is quite different as it focuses on assets switching from one style index to another, rather than inclusion or exclusion in a unique index.
The conclusion of the present study is that the arbitrary segregation of assets in style indices can cause the price of some assets to diverge from their fundamental value, in contradiction with the market efficiency hypothesis. The effect is particularly strong since it concerns S&P 500 stocks which are among the most traded.
Barberis, N., and A. Shleifer. 2003. Style investing. Journal of Financial Economics 68, 161-199.
Denis, D. K., J. J. McConnell, A. V. Ovtchinnikov, and Y. Yu. 2003. S&P 500 index additions and earnings expectations. Journal of Finance 58, 1821-1840.
Vijh, A. 1994. S&P 500 trading strategies and stock betas. Review of Financial Studies 7, 215-251.