The Heisenberg Uncertainty Principle asserts a lovely paradox of physics: The act of measuring the whereabouts and momentum of subatomic particles distorts the very qualities you seek to measure.
There is, of late, a growing suggestion of something similar occurring on Wall Street. We refer to stock-index funds, those mindless pots of cash being shoveled into stocks not by name, but by number. The number in question is 500, as in Standard & Poor's -- and the uncertainty regards whether indexing is affecting underlying stock prices.
This was not remotely an issue in 1976, when Vanguard Group introduced the index fund. Burton Malkiel, an academic proponent of automatic, indexed, eyes-closed investing, recalled, not quite literally, "For a couple of years, I think Jack Bogle [Vanguard's chairman] and I were the only shareholders." The idea was to let investors duplicate, a broad market average -- not to influence it.
In recent years, as more people have shut their eyes, it has been clear that when stocks are admitted to the S&P 500 they immediately rise, as though a bunch of automatons were compelled to buy newly included stocks at whatever the price. And in fact, they are. It's like a shopping mall in which the entire town turns out to buy anytime a store moves in -- and keeps buying at every store, every week. (This column recommends selective shopping for value-priced goods -- with one exception. People in retirement plans with limited options do not have the freedom to pick and choose. For them, an index may be the least unattractive choice.)
Several studies have documented the short-term effects of indexers. The latest, by Richard Mendenhall of the University of Notre Dame and Anthony Lynch of New York University, found that in the week or so between when S&P announced it was adding a stock to the day it actually did so, the issue rose an average of 7%. This could not be coincidence. Even in this market, 7% a week is pushing it. T. Rowe Price and Goldman Sachs did their own research and got similar results.
What, if anything, they signify, is trickier. Grant that, in 1996, people put $16 billion into mutual funds indexed to the S&P 500 -- equal to the total of such investing over the previous four years. Grant that the S&P 500 rose more than most portfolios. And grant that the S&P 500 is high -- high relative to earnings, high relative to bond yields, and high relative to Venus, Saturn and Uranus. (If you buy $100 of the S&P 500, you can expect to get only $6.10 in earnings over the next year, whereas $100 invested in the long bond yields $6.90 in interest, no questions asked.)
Whether stocks in the index hang on to their "membership premium" or gradually seek their level as eyes-open money managers sell them is debatable. Mr. Mendenhall also looked at stocks for the 10 days after they joined the index. In that span, they lost 2%.
Perhaps, some amount of premium endures. But the amount of indexed money, in relative terms, is still small. The S&P 500 accounts for seven-tenths of the stock market's total capitalization (a proportion that has actually fallen a bit as indexing has taken off, according to S&P). One would, therefore, expect those companies to attract a goodly share of available capital. But of total mutual-fund sales last year, less than 10% went to S&P indexed funds. Including pension funds and others, S&P estimates that a total of $450 billion is invested in funds tied to its index. But the companies are worth $5.6 trillion. So, in effect, 8% -- and only 8% -- of their shareholders are pledged to not selling. If you are trying to explain a raging bull market, you will have to do better.
And by itself, each stock in the S&P 500 is not, in fact, raging -- only the 25 or 50 biggest companies in the bunch are. This selectivity is the work of stock-pickers, not indexers. Some of the enthusiasm of the former may be warranted. One investor who I know judges stocks by their value, not by their race, religion, color, or market cap, observes that in an era of consolidation, the more efficient companies also tend to be bigger ones. "It's hard for me to believe that there is a better hospital chain than Columbia/HCA," he notes. Companies with the economies of scale to go overseas also tend to be bigger. For similar reasons -- gains in efficiency, ability to leverage new technology -- Charles Akre, a bottom-up money manager in Arlington, Va., is "fooling around with large banks."
Indexers are benefiting from this faith in renewed and resurgent big corporations, but by shunning selectivity and even any research they suffer from an uncertainty principle of their own. Should big stocks or any stocks become overvalued, they will be the last to know.