Much stock market behavior is driven by index (and closet index) funds

12 Oct 2011 by Jim Fickett.

When studying an individual stock, keep in mind that often it will move with an index, or with a sector ETF, rather than being valued in line with its own fundamentals.

Seth Klarman's Margin of Safety makes the point that institutional investors own a large fraction of all shares. And most institutional investors try to stay close to the indexes, since making truly independent decisions can ruin the career of mediocre fund managers. Thus individual stocks in an index often move with the index. I would add that something similar happens with ETFs – ETFs are very popular, and individual stocks will often move with a sector or other group just because a popular ETF gets more attention than the individual stock.

This is both good and bad for the individual investor. When a stock you have taken time to understand moves with an index, instead of being priced as would make sense based on fundamentals, it is easy to be taken off guard. On the other hand, when everything moves together, it can create opportunities. And less well-known stocks, not included in indexes or common ETFs, can sometimes be underpriced just because the institutional investors ignore them.

From Klarman:

Index Funds: The Trend Toward Mindless Investing …

Yet even very large capitalization stocks have limited liquidity at a given time. Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yesterday. In effect, people are willing to pay more for that stock just because it has become part of an index.

By way of example, when Blockbuster Entertainment Corporation was added to the Standard and Poor's 500 Index in early 1991, its total market capitalization increased in one day by over $155 million, or 9.1 percent, because so many fund managers were “obliged” to buy it. Indeed, Barron's has calculated that stocks added to the Standard & Poor's 500 Index outperformed the market by almost 4 percent in the first week after their inclusion. …

Conclusion

Investors must try to understand the institutional investment mentality for two reasons. First, institutions dominate financial-market trading; investors who are ignorant of institutional behavior are likely to be periodically trampled. Second, ample investment opportunities may exist in the securities that are excluded from consideration by most institutional investors. Picking through the crumbs left by the investment elephants can be rewarding.