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The impact of passive investing on corporate valuations
Eric Belasco
Department of Agricultural Economics and Economics, Montana State University, Bozeman, Montana, USA
Michael Finke
Department of Personal Financial Planning, Texas Tech University, Lubbock, Texas, USA, and
David Nanigian
The American College, Bryn Mawr, Pennsylvania, USA
Abstract
Purpose – The purpose of this paper is to explore the impact of S&P 500 index fund money ﬂow on the valuations of companies that are constituents of the index and those that are not. Design/methodology/approach – To examine the impact of passive investing on corporate valuations, the authors run panel regressions of pricetoearnings ratio on aggregate money ﬂow into S&P 500 index funds and control for various accounting variables that impact pricetoearnings ratio. These regressions involve two samples of stocks. The ﬁrst sample consists of S&P 500 constituents. The second consists of largecap stocks that are not constituents of the S&P 500. The authors also run a set of separate regressions with pricetobook ratio rather than pricetoearnings ratio as the dependent variable. Findings – It is found that the valuations of S&P 500 constituents increased by 139 to 167 basis points relative to nonconstituents, depending on valuation metric, due to S&P 500 index fund money ﬂow when evaluated at mean values of money ﬂow and valuation metrics. The valuations of ﬁrms within the S&P 500 index respond positively to changes in S&P 500 index fund money ﬂow while the valuations of ﬁrms outside the index do not. Additionally, the impact of money ﬂow on valuations persists the month after the ﬂow occurs, suggesting that the impact does not dissipate over time. Practical implications – Mispricings among individual stocks arising from index fund investing may reduce the allocative efﬁciency of the stock market and distort investors’ performance evaluations of actively managed funds. Originality/value – The paper is the ﬁrst to explore the longrun relationship between S&P 500 index fund money ﬂow and corporate valuations.
Keywords Investments, Indexing, Fund management, Active management, Passive management, Index fund, Index premium, Demand curves for stocks, S&P 500
Paper type Research paper
JEL classiﬁcation – G11 (investment decisions), G12 (asset pricing), G23 (private ﬁnancial institutions) The authors appreciated the feedback given by Ozzy Akay, David Blitzer, Dale Domian, Harold Evensky, Scott Hein, Jason Hsu, Vitali Kalesnik, Masha Rahnama, John Salter, William Waller, and Walter Woerheide, and the excellent research assistance provided by Melissa Cenneno. The authors also thank seminar participants at Texas Tech University (hosted by the Division of Personal Financial Planning) and The American College, as well as participants at the Academy of Financial Services Annual Meeting, the Financial Management Association International Annual Meeting, and the Journal of Indexes Editorial Board Meeting for their comments and suggestions.
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Received August 2012 Revised January 2012, March 2012 Accepted May 2012
Managerial Finance Vol. 38 No. 11, 2012 pp. 10671084 q Emerald Group Publishing Limited
03074358
DOI 10.1108/03074351211266793
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I. Introduction Neoclassical asset pricing theory assumes that the price of a stock changes as a result of new information about a corporation’s value to its shareholders. Event studies on changes to the composition of an index are frequently used to examine whether a nonvaluation motivated change in the quantity demanded of a given security results in a change in its price. While these studies suggest an increase in valuation resulting from
inclusion in the index, it is possible that the increase accurately reﬂects greater intrinsic value of the stock from increased liquidity. This study explores the impact of S&P 500 index fund money ﬂow on the valuations of companies that are constituents of the index and those that are not. We ﬁnd that money ﬂow increases the pricetoearnings and pricetobook ratios of companies that are constituents relative to those that are not. This provides evidence of downwardsloping demand curves for stocks. In a broad review of studies investigating indexation price effects, Brealey (2000) identiﬁes a trend over the period 1966 to 1995 toward larger positive abnormal returns following the addition of a stock to the S&P 500 and larger negative abnormal returns following a deletion of a stock from the index. Petajisto (2011) ﬁnds that the average abnormal returns to additions are 8.8 percent in the period 1990 through 2005, and the average abnormal returns to deletions are 2 15.1 percent. The percentage of US equity mutual fund assets invested in index funds increased from 1.0 percent in 1984 to 12.4 percent in 2002 (French, 2008), and more than half of all US equity index fund assets are invested in S&P 500 index funds (Investment Company Institute, 2011). This increase in passive equity investment among S&P 500 ﬁrms suggests that the growth of the event effects may be largely due to the shift toward passive investing. The slope of a demand curve for a company’s stock is gauged by the (absolute)
magnitude of its price elasticity of demand, E ^{D} _{} . In the stock market setting:
P
ð1Þ
where Q denotes the quantity of shares of a company’s stock demanded by investors and P denotes the price per share of the company’s stock. This concept is shown in Figure 1. Shleifer (1986) and Petajisto (2011) estimate that E ^{D} _{} is near unity. This runs contrary to
the predictions of Fama’s (1970) efﬁcient market hypothesis, which predicts that arbitrage trading will correct mispricings among stocks[1]. Arbitrageurs have not ﬂattened the demand curve. Petajisto (2011) also discovers that in the period 1990 through 2005 the average abnormal returns to additions to the Russell 2000 was 8.0 percent and the average abnormal returns to deletions was 2 13.4 percent. Price effects in the purely market capbased Russell 2,000 that are similar to those observed in the S&P 500 provide further evidence of downwardsloping demand curves for stocks. In a related strand of research, Baberdis et al. (2005) theorize that, in the presence of limited arbitrage, money ﬂowing into a segment of the market impacts the correlation of returns between stocks in that segment. Consistent with the authors’ habitat theory of return comovement, they ﬁnd that a stock’s correlation with other stocks in the S&P 500 increases when it is added to the index and, commensurate with the trend towards S&P 500 index fund investing, the correlations have increased in recent years. Relatively higher stock ownership by active funds reduces the magnitude of the correlation between stocks and the index; however, index additions result in increased
E ^{D} ¼
P
DQ
=
Q
D P = P
P
;
_{}
Quantity (Volume of stock)
Note: This figure shows how the price of a stock responds to a change in the quantity of the stock demanded by market participants when the demand curve is downwardsloping
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Figure 1. Supply and demand
passive ownership share and a decrease in ﬁrmspeciﬁc price changes (Ye, 2011). Wermers and Yao (2011) ﬁnd stronger pricing anomalies, such as those related to momentum and accruals, among stocks with high levels of passive fund ownership, which provides additional evidence that index fund investing impedes the efﬁciency of capital markets. Increasing correlation among funds within the S&P 500 and pricing anomalies associated with increased passive investment may counteract alternative explanations for the gains from S&P 500 inclusion, including reduced agency costs from increased monitoring by analysts (Yu, 2008). Event studies only partially address price effects associated with index fund investing. This is because investor cash is continuously ﬂowing in and out of index funds, yet changes to the composition of an index only occur a few times a year. Changes in the quantity of a stock demanded by index fund managers as a result of fund ﬂows may also impact the price of stocks if stocks within the index exhibit downwardsloping demand curves. Goetzmann and Massa (2003) examine the relationship between index fund ﬂows and returns on the index and ﬁnd that a strong sameday relationship exists. However, it is difﬁcult to determine whether the ﬂows are driving the returns or vice versa. To disentangle demand effects from potential feedback effects, the authors perform a GewekeMesseDent (1982) (GMD) test. The GMD test conﬁrms that the direction of causality is from ﬂows to returns. However, the GMD test is weak if the causality is at a higher frequency than the data. This motivated the authors to conduct a series of tests using higher frequency data, which arrive at the same results as the GMD test. Hence, strong evidence suggests that ﬂows drive returns. However, the question of whether or not S&P 500 index fund money ﬂow has inﬂated the fundamental value of companies that are constituents of the index relative to nonconstituents has not yet been determined.
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We hypothesize that ﬂows into S&P 500 index funds positively impact the PE ratio of companies that are in the index relative to those that are not. In an unpublished manuscript, Morck and Yang (2002) ﬁnd evidence that money ﬂow into index funds alters the Tobin’s Q ratios. Our empirical work is an extension of Morck and Yang and is different in several ways. First, we perform regressions that involve net cash ﬂows (NCF) rather than timeseries plots. Second, we take a comprehensive view of index fund assets by looking at all S&P 500 index funds, including exchange traded funds (ETF). Third, we focus on ratios that are more commonly used by practitioners to gauge valuation. Fourth, we use more recent data. This paper examines the extent to which price multiple measures of valuation are impacted by the trend toward passive investing. To conduct this analysis, we run panel regressions of pricetoearnings ratio (PE) on aggregate NCF into S&P 500 index funds controlling for various accounting variables that impact PE. Additionally, regressions are run with pricetobook ratio (PB), an alternative valuation measure, as the dependent variable[2]. The results from regression models that control for aggregate US equity fund NCF demonstrate that the valuations of constituents increased by 139 to 167 basis points relative to nonconstituents, depending on valuation metric, due to S&P 500 index fund NCF when evaluated at mean value of NCF and valuation metrics. Valuations of ﬁrms within the S&P 500 index respond positively to changes in S&P 500 NCF while the values of ﬁrms outside the index do not increase during the same time period. Additionally, ﬂow induced pricepressure effects do not appear to dissipate over time.
II. Data To maximize coverage of index fund assets, we incorporate both mutual fund and ETF data into our analysis. Mutual fund and ETF data come from Morningstar Direct. Index and individual stock data come from Compustat. Because Morningstar’s coverage of fund ﬂows begins in February 1993, we control for lagged onemonth fund ﬂows, and because Compustat’s pricedividendsearnings ﬁle ends in February 2007, the sample period spans March 1993 to February 2007.
A. Description of data on fund ﬂows
Monthly NCFs are gathered from Morningstar Direct’s fund ﬂows database on all USdomiciled openend mutual funds and ETFs excluding money market funds and funds of funds[3]. We gather two timeseries of NCFs. The ﬁrst consists of all S&P 500 index funds which, based on conversations with Morningstar, is deﬁned as all funds with an institutional category of “S&P 500 Tracking.” The second consists of all US equity funds and is used to control for marketwide fund NCF in our regression analysis; it consists of all funds with a US broad asset class of “US Stock.”
B. Description of data on S&P 500 index valuation
For each month in the sample, information on monthend closing prices, earnings per share, book value per share, and a variable indicating historical S&P 500 index constituency status is gathered from Compustat on all publiclytraded largecap companies. Following Fama and French (1996), we deﬁne largecap as greater than median NYSE market capitalization and gather monthly market capitalization breakpoints from Kenneth French’s web site. We restrict our analysis to only largecap companies in order to prevent the “size premia” from biasing our results. We exclude
nonoperating establishments, ﬁnancial services companies (due to nonreporting of working capital data), and companies headquartered outside of the USA (ADRs, ADSs, AMs, and GDRs)[4] from our analysis. We deﬁne earnings per share as 12 month moving average quarterly as reported basic earnings per share. We deﬁne book value per share as the total value of common equity excluding intangible assets based on ﬁscal year end data divided by common shares outstanding. Additionally, for each month in the sample, data on various accounting line items are gathered from Compustat to control for return on invested capital (ROIC), free cash ﬂow (FCF) growth, and the internal growth rate of dividends, which are commonly regarded to impact price multiple ratios[5]. To control for seasonality, all income statement and statement of cash ﬂow items are deﬁned as the cumulative value of the associated variables over the prior fourquarters. Balance sheet items are deﬁned as the associated value as of the most recent quarter. Companies lacking fourquarters of continuous data in a given month are excluded from analysis for that period. Line item values that are coded by Compustat as “not meaningful” or “insigniﬁcant” are imputed as zero. Following Damodaran (2007), ROIC is calculated as aftertax operating income divided by the book value of lagged fourquarter invested capital, where aftertax operating income is calculated as net income plus aftertax interest expense minus aftertax nonoperating income. The applicable tax rate is assumed to be the maximum marginal tax rate in the associated time period. Based on information provided by the Urban Institute and the Brookings Institution (2010), the effective tax rate was 34 percent prior to 1993 and 35 percent from 1993 through 2007. Following Brealey et al. (2006), FCF is calculated as net income plus depreciation and amortization expense minus the change in working capital minus capital expenditures. In the interest of preserving degrees of freedom, FCF Growth is deﬁned
as the percentage change in FCFs between the current and lagged fourth quarter. Following Brealey et al. (2006), the internal growth rate of dividends is calculated as the product of the retention ratio (also known as the plowback ratio) and return on equity. The retention ratio is equal to one minus the indicated annual dollar value of dividends paid to common shareholders divided by income before extraordinary items (adjusted for common stock equivalents). The return on equity is calculated as income before extraordinary items divided by lagged fourquarter book value of equity. To control for the effect of outliers and data entry errors from the data feeds, all accounting variables are winsorized (i.e. truncated) at the 1 percent tails.
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III. Methods
A series of leastsquares regressions is used to analyze the impact of money ﬂow into
S&P 500 index funds on the valuation of individual companies. Our choice of a panel study involving individual companies in contrast to timeseries analysis involving portfolios of stocks was driven by two rationales. First, the panel study approach
allows us to better control for effects across the crosssection and time domains. Second, more information is utilized through the panel approach as our results are not limited to a single portfolio or a moment in time. We employ a ﬁxed effects model with a oneway error term in our regression analysis
to account for companyspeciﬁc individual effects. The use of this model is supported by
the results from the Hausman’s speciﬁcation test for ﬁxed versus random effects.
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A. Description of regression model To test our hypothesis, we estimate regressions that are variants of the following form:
PE _{ð} _{i} _{;}_{t} _{Þ} ¼ a _{ð} _{i} _{;}_{t} _{Þ} þ b _{1} £ ROIC _{ð} _{i} _{;} _{t} _{Þ} þ b _{2} £ FCF
growth _{ð} _{i} _{;}_{t} _{Þ} þ
b 3
£ Expected growth rate of dividends _{ð} _{i} _{;} _{t} _{Þ} þ b _{4} £ Aggregate
^{ð}^{2}^{Þ}
where subscript i denotes the individual stock and subscript t denotes the month. We also run a set of regressions with an alternative dependent variable, PB.
IV. Results Table I presents summary statistics on the main variables of interest. NCFs are reported in billions of dollars. It is interesting to note that S&P 500 index fund NCFs are relatively more volatile than those of the aggregate market of US equity funds. For example, the standard deviation of S&P 500 index fund NCF is 2.25 times greater than its mean value, yet the standard deviation of aggregate US equity fund NCF is only 0.90 times the size of its mean value. The factors that affect aggregate US equity fund NCF, such as aggregate demand for liquidity among market participants, also affect S&P 500 index fund NCF. However, the Pearson correlation coefﬁcient between the two money ﬂow variables is only 0.55. The correlation coefﬁcient is not indicative of multicollinearity, suggesting that the increased popularity of indexing over our sample period, in addition to marketwide factors, contribute to the high volatility of S&P 500
Mean 
SD 
25th percentile 
Median 
75th percentile 

Panel A: net cash ﬂow variables ( T ¼ 168 ) S&P 500 index fund net cash ﬂow US equity fund net cash ﬂow 
0.97 
2.18 
0.14 
0.88 
2.06 
8.22 
7.43 
4.07 
8.44 
12.20 

Panel B: ﬁnancial variables – constituents sample – PE regressions ( n ¼ 622 ) 

Pricetoearnings ratio Return on invested capital Free cash ﬂow growth Expected growth rate of dividend stream 
21.03 
39.19 
13.95 
19.61 
28.23 
0.16 
0.38 
0.06 
0.12 
0.19 

(1.23) 
4.94 
(2.07) 
(1.23) 
(0.41) 

0.17 
0.26 
0.08 
0.16 
0.24 

Panel C: ﬁnancial variables – nonconstituents sample – PE regressions ( n ¼ 1,864 ) 

Pricetoearnings ratio Return on invested capital Free cash ﬂow growth Expected growth rate of dividend stream 
22.20 
47.13 
13.47 
20.69 
32.04 
0.15 
0.38 
0.06 
0.12 
0.19 

(1.23) 
5.79 
(2.34) 
(1.40) 
(0.38) 

0.15 
0.31 
0.08 
0.16 
0.25 

Panel D: ﬁnancial variables – constituents sample – PB regressions ( n ¼ 619 ) 

Pricetobook ratio Return on invested capital Free cash ﬂow growth Expected growth rate of dividend stream 
4.25 
4.30 
2.03 
3.07 
4.91 
0.16 
0.39 
0.06 
0.12 
0.19 

(1.23) 
4.97 
(2.08) 
(1.24) 
(0.41) 

0.16 
0.24 
0.07 
0.16 
0.24 

Panel E: ﬁnancial variables – nonconstituents sample – PB regressions ( n ¼ 1,851 ) 

Pricetobook ratio Return on invested capital Free cash ﬂow growth Expected growth rate of dividend stream 
4.73 
5.15 
2.14 
3.30 
5.47 
0.15 
0.38 
0.06 
0.12 
0.19 

(1.24) 
5.80 
(2.35) 
(1.41) 
(0.39) 

0.15 
0.29 
0.07 
0.16 
0.24 
Table I. 
Notes: This table reports summary statistics of regression variables; net cash ﬂow variables are 
Summary statistics 
reported in billions of dollars 
index fund NCF relative to its mean. The heterogeneity is shown in the time plots of the two series in Figure 2. It is also interesting to note that the ROIC, FCF growth, and expected growth rate of dividends of S&P 500 constituents are similar to those of nonconstituents.
A. Description of results from the analysis of pricetoearnings ratio Table II presents the results from equations that relate PE ratio to the explanatory variables. The odd columns present results from regressions involving the sample of S&P 500 index constituents. The even columns present results from regressions involving the sample of largecap stocks that are not constituents of the S&P 500 index. Column (5) shows that the PE ratios of constituents are positively and signiﬁcantly (at the 1 percent level) impacted by S&P 500 index fund NCF. The regression coefﬁcient is economically meaningful as well. The overall mean of PE was 21.03 and the timeseries mean of S&P 500 index fund NCF was $0.97 billion. When evaluated at these average values, S&P 500 index fund NCF corresponds to a 1.7 percent increase in the value of constituents:
0:37 £ 0:97
21:03
¼ 1:7%:
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The results from a regression of the same model on the sample of nonconstituents is conveyed in column (6). The results from the sample of nonconstituents are not signiﬁcant, perhaps due to S&P 500 index fund NCF subsuming the effect of aggregate US equity fund NCF. Therefore, regressions which control for aggregate US equity fund NCF are run. The results from these regressions for constituents and nonconstituents are conveyed in
40,000,000,000
30,000,000,000
20,000,000,000
10,000,000,000
0
(10,000,000,000)
(20,000,000,000)
(30,000,000,000)
(40,000,000,000)
Notes: This figure plots the timeseries of aggregate NCF into US equity funds and into the subset of such funds that Morningstar categorizes as having an objective of tracking the S&P 500 Index; the sample period spans March 1993February 2007
Figure 2. Time plot of money ﬂows
evennumbered columns report results from the sample of stocks outside of the S&P 500 index with greater than median market capitalizations; net cash
ﬂow variables are reported in billions of dollars; coefﬁcients are estimated using the ﬁxed effects model; standard errors are given below the regression
Nonconstituents
Notes: Signiﬁcant at: ^{*} p , 0.10, ^{*} ^{*} p , 0.05 and ^{*}^{*}^{*} p , 0.01; oddnumbered columns report results from the sample of stocks in the S&P 500 index;
14.66 ^{*}^{*}^{*}
0.10 ^{*}^{*}^{*}
6.07 ^{*}^{*}^{*}
0.06 ^{*} ^{*}
(0.15) *
31.81 ^{*}
(0.12)
(0.08)
(0.03)
(0.03)
(0.09)
(0.71)
(0.03)
(0.52)
(16.35)
0.30
0.01
(8)
1,864
Constituents
47.46 ^{*}^{*}^{*}
0.12 ^{*}^{*}^{*}
2.80 ^{*}^{*}^{*}
0.25 ***
0.07 ^{*}^{*}^{*}
14.70 ^{*}^{*}^{*}
0.22 * *
(0.08)
(0.03)
(0.03)
(0.08)
(0.78)
(0.03)
(0.46)
(0.04)
(11.03)
(7)
0.14
622
Nonconstituents
6.01 ^{*}^{*}^{*}
14.69 ^{*}^{*}^{*}
31.95 ^{*}
(0.03)
(0.03)
(0.07)
(0.07)
(0.71)
(0.52)
(0.03)
(16.35)
0.30
0.01
(6)
1,864
Constituents
0.37 ***
48.17 ^{*}^{*}^{*}
2.72 ^{*}^{*}^{*}
0.36 ***
14.84 ^{*}^{*}^{*}
(0.07)
(0.07)
(0.03)
(0.46)
(0.78)
(0.04)
(11.03)
(5)
0.14
622
Nonconstituents
6.10 ^{*}^{*}^{*}
14.65 ^{*}^{*}^{*}
0.08 ^{*}^{*}^{*}
0.05 ^{*} ^{*}
31.78 ^{*}
(0.02)
(0.02)
(0.29)
(0.52)
(0.71)
(16.35)
1,864 0.30
0.01
(4)
Constituents
2.74 ^{*}^{*}^{*}
14.68 ^{*}^{*}^{*}
47.19 ^{*}^{*}^{*}
^{*}^{*}^{*}
^{*}^{*}^{*}
0.09 (0.02)
0.14 (0.02)
(0.78)
(0.46)
(0.03)
(0.04)
(11.03)
(3)
622 0.14
Nonconstituents
6.02 ^{*}^{*}^{*}
14.68 ^{*}^{*}^{*}
31.94 ^{*}
(0.52)
(0.03)
(0.71)
(16.35)
1,864 0.30
0.01
(2)
Constituents
2.57 ^{*}^{*}^{*}
47.97 ^{*}^{*}^{*}
14.85 ^{*}^{*}^{*}
(0.46)
(0.03)
(0.78)
(0.04)
(11.04)
(1)
622 0.14
index
Return on invested capital Free cash ﬂow growth
Expected growth rate of dividend stream Aggregate net cash ﬂow Lagged aggregate net cash ﬂow
index fund
ﬂow
cash 500
500 ﬂow
Observations
R ^{2}
net S&P
coefﬁcients
Adjusted
Intercept
S&P cash
Lagged
fund
net
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Table II. Pricetoearnings ratio regression results (March 1993February 2007)
columns (7) and (8), respectively. After controlling for aggregate US equity fund NCF, the negative impact of S&P 500 index fund NCF on the PE ratio of nonconstituents becomes statistically signiﬁcant at the 10 percent level. The difference in the regression coefﬁcients between the constituent and nonconstituent samples are quantitatively unchanged relative to the models that do not control for aggregate US equity fund NCF. It is also interesting to note that fund ﬂows do not explain much of the total variation in corporate valuations, as the introduction of fund ﬂow variables into the regression models (columns (5) through (8)) does not improve adjusted R ^{2} values or substantially alter the value of the regression coefﬁcients associated with the valuation control variables. The results from these regressions fail to show that NCF into S&P 500 index funds explains a substantial amount of the total variation of corporate valuations. However, they do show that money ﬂow into S&P 500 index funds leads to considerable changes in the value of companies in the index relative to those outside of the index. This central ﬁnding is consistent with the hypothesis. A related question is whether or not pricepressure effects dissipate over time. To address this, we examine the coefﬁcients on lagged S&P 500 index fund NCF. If market participants correct the ﬂow induced pricepressure effects, then we would observe a reversal or at least a reduction in the difference in the coefﬁcients on lagged S&P 500 index fund NCF between the constituent and nonconstituent samples relative to the difference in the coefﬁcients on contemporaneous S&P 500 index fund NCF. However, this is not apparent in the data. The differences in the coefﬁcients on the lagged and contemporaneous values in the regressions that do not control for aggregate US equity fund NCF ((5) and (6)) are 0.39 and 0.40, respectively. The difference in the coefﬁcients on the lagged and contemporaneous values for S&P 500 index fund NCF in the regressions that do control for aggregate NCF ((7) and (8)) are both 0.37. The difference in the coefﬁcients on lagged S&P 500 index fund NCF between the constituent and nonconstituent samples are similar to the difference in the coefﬁcients on contemporaneous S&P 500 index fund NCF. Moreover, the standard errors of the coefﬁcients on the lagged values are not greater than those associated with the contemporaneous values. The results from this analysis do not show that an adjustment process exists.
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B. Description of results from the analysis of pricetobook ratio Table III presents the results from equations that relate PB ratio to the explanatory variables. The results pertaining to this alternative valuation metric are similar to those obtained through the use of pricetoearnings ratio. While S&P 500 index fund NCF does not explain much of the total variation in corporate valuations, it does positively impact on the valuation of constituents relative to nonconstituents. When evaluated at the overall average value of PB ratio (4.25), the PB ratio of constituents increased by a statistically signiﬁcant (at the 1 percent level) 2.1 percent due to S&P 500 index fund NCF when evaluated at its timeseries mean ($0.97 billion). The PB ratio of nonconstituents also increased but only by 0.6 percent when evaluated at mean levels. We attribute the slight increase in the value of nonconstituents to aggregate US equity fund NCF, which were omitted from this set of regressions. After controlling for aggregate US equity fund NCF, when evaluated at the overall average of PB ratio, the PB ratio of constituents increased by a statistically signiﬁcant (at the 1 percent level) 1.6 percent while the value of nonconstituents was quantitatively unchanged.
evennumbered columns report results from the sample of stocks outside of the S&P 500 index with greater than median market capitalizations; net cash
ﬂow variables are reported in billions of dollars; coefﬁcients are estimated using the ﬁxed effects model; standard errors are given below the regression
Nonconstituents
Notes: Signiﬁcant at: ^{*} p , 0.10, ^{*} ^{*} p , 0.05 and ^{*}^{*}^{*} p , 0.01; oddnumbered columns report results from the sample of stocks in the S&P 500 index;
0.01 ^{*}^{*}^{*}
0.62 ^{*}^{*}^{*}
0.02 ^{*}^{*}^{*}
2.10 ^{*}^{*}^{*}
0.01 ^{*}^{*}^{*}
(0.02) * *
5.81 ^{*} ^{*}
(0.01)
(0.00)
(0.00)
(0.01)
(0.00)
(2.29)
(0.04)
(0.06)
0.62
0.01
(8)
1,851
Constituents
5.92 ^{*}^{*}^{*}
0.02 ^{*}^{*}^{*}
0.07 ^{*}^{*}^{*}
9.74 ^{*}^{*}^{*}
0.02 ^{*}^{*}^{*}
0.12 ^{*}^{*}^{*}
0.06 ***
(0.00)
(0.01)
(0.00)
(0.00)
(0.01)
(0.85)
(0.00)
(0.04)
(0.07)
(7)
0.57
619
Nonconstituents
6.06 ^{*}^{*}^{*}
0.03 ^{*}^{*}^{*}
2.11 ^{*}^{*}^{*}
0.01 ^{*}^{*}^{*}
0.61 ^{*}^{*}^{*}
(0.01)
(0.01)
(0.06)
(0.04)
(2.29)
(0.00)
0.62
0.01
(6)
1,851
Constituents
5.95 ^{*}^{*}^{*}
0.10 ^{*}^{*}^{*}
0.09 ***
0.09 ^{*}^{*}^{*}
9.87 ^{*}^{*}^{*}
(0.01)
(0.01)
(0.00)
(0.00)
(0.04)
(0.07)
(0.86)
(5)
0.57
619
Nonconstituents
0.02 ^{*}^{*}^{*}
0.62 ^{*}^{*}^{*}
0.01 ^{*}^{*}^{*}
2.10 ^{*}^{*}^{*}
0.01 ^{*}^{*}^{*}
5.83 ^{*} ^{*}
(0.00)
(0.00)
(0.00)
(0.06)
(0.04)
(2.29)
1,851 0.62
(4)
Constituents
9.66 ^{*}^{*}^{*}
5.91 ^{*}^{*}^{*}
^{*}^{*}^{*}
^{*}^{*}^{*}
0.10 ^{*}^{*}^{*}
0.03 (0.00)
0.02 (0.00)
(0.00)
(0.00)
(0.07)
(0.04)
(0.85)
(3)
619 0.57
Nonconstituents
0.01 ^{*}^{*}^{*}
6.01 ^{*}^{*}^{*}
2.11 ^{*}^{*}^{*}
0.60 ^{*}^{*}^{*}
(0.06)
(0.04)
(0.00)
(2.29)
1,851 0.62
(2)
Constituents
9.82 ^{*}^{*}^{*}
^{*}^{*}^{*}
^{*}
(0.86)
0.06 (0.03)
5.95 (0.07)
(0.00)
(0.00)
(1)
619 0.57
index
Return on invested capital Free cash ﬂow growth
Expected growth rate of dividend stream Aggregate net cash ﬂow Lagged aggregate net cash ﬂow S&P 500 index fund net cash ﬂow
ﬂow
cash 500
Observations
R ^{2}
net S&P
coefﬁcients
Adjusted
Intercept
Lagged
fund
MF
38,11
1076
Table III. Pricetobook ratio regression results (March 1993February 2007)
To examine the possibility that ﬂow induced pricepressure effects dissipate over time, we turn to the coefﬁcient on the lagged value of S&P 500 index fund NCF. Interestingly, the difference in the coefﬁcient on lagged S&P 500 index fund NCF between the constituent and nonconstituents samples ((5) and (6)) is 0.08 yet the difference in the coefﬁcient on the contemporaneous values between the two samples is 0.06. The same phenomena is observed among the regressions that control for aggregate US equity fund NCF ((7) and (8)). While the slightly greater impact of lagged S&P 500 index fund NCF than contemporaneous S&P 500 index fund NCF on valuations is somewhat perplexing, it clearly provides no support for the idea that the pricepressure effects dissipate over time. Lastly, we acknowledge the concern that our results may be partially an artifact of the price effects associated with changes to the S&P 500 index. Evidence of asymmetric price responses upon changes to index constituency status, detailed in Chen et al. (2004), and competing explanations for the price effect validate this concern. To examine how sensitive our results are to the event effects, we run an additional set of regressions in which we exclude companies from our samples if they were either added to or deleted from the S&P 500 index over the prior two months. The results obtained from these regressions were quantitatively unchanged.
The impact
of passive
investing
1077
C. Subperiod analysis
Tables IV and VI provide subperiod results for March 1993 through February 2000 for pricetoearnings ratio and pricetobook ratio, respectively. Tables V and VII provide subperiod results for March 2000 through February 2007 for pricetoearnings ratio and pricetobook ratio, respectively. Although the impact of NCF on valuation is statistically signiﬁcant and positive among constituent ﬁrms in both subperiods, the effect is more pronounced between 1993 and 2000. This may be due to heavier inﬂows into index funds during this period (the fraction of total US equity mutual fund assets tracking the S&P 500 increased by 151 percent between 1993 and 2000 versus 29 percent between 2000 and 2006). The more pronounced effect in the ﬁrst subperiod may also be due to the increased popularity of day trading over that period (Tables VI and VII). As in the full period analysis, the subperiod analysis also does not provide much evidence to show that fund money ﬂow explains much of the total variation in corporate valuations but the analysis also does not show that ﬂow induced valuation effects dissipate over time.
V. Concluding remarks
A. Summary of research ﬁndings
This study is the ﬁrst to explore the longrun relationship between S&P 500 index fund money ﬂow and corporate valuations. Through a series of panel regressions, we examine whether money ﬂow into S&P 500 index funds impacts the pricetoearnings ratio and pricetobook ratio of ﬁrms within and outside the index. The results are consistent with the hypothesis that money ﬂow into S&P 500 index funds positively impacts the price multiples of companies that are in the index relative to those that are not. The impact on valuations persists the month after the ﬂow occurs, suggesting that the impact does not dissipate over time. These results are consistent with the theory
Notes: Signiﬁcant at: ^{*} p , 0.10, ^{*} ^{*} p , 0.05 and ^{*}^{*}^{*} p , 0.01; oddnumbered columns report results from the sample of stocks in the S&P 500 index; evennumbered columns report results from the sample of stocks outside of the S&P 500 index with greater than median market capitalizations; net cash ﬂow variables are reported in billions of dollars; coefﬁcients are estimated using the ﬁxed effects model; standard errors are given below the regression
Nonconstituents
(0.74) ***
0.18 ^{*}^{*}^{*}
19.56 ^{*}^{*}^{*}
0.80 ^{*}^{*}^{*}
0.12 ^{*}^{*}^{*}
0.18 ***
(51.41) ^{*}
(0.05)
(0.06)
(0.27)
(0.23)
(1.15)
(0.04)
(0.22)
(26.69)
0.04
0.40
(8)
1,335
Constituents
18.37 ^{*}^{*}^{*}
0.22 ^{*}^{*}^{*}
0.81 ***
0.41 ^{*}
(0.05)
(0.01)
(0.06)
(0.06)
(0.29)
(0.25)
(1.54)
(0.22)
(0.05)
(24.98)
(7)
0.18
9.92
0.21
493
Nonconstituents
0.12 ^{*}^{*}^{*}
0.74 ^{*}^{*}^{*}
19.61 ^{*}^{*}^{*}
(46.47) ^{*}
(0.12)
(0.24)
(0.22)
(0.21)
(0.04)
(1.15)
(26.69)
0.40
0.15
(6)
1,335
Constituents
0.95 ***
18.54 ^{*}^{*}^{*}
0.39 ^{*}
0.47 ^{*}
(0.02)
(0.25)
(0.24)
(0.05)
(0.22)
(1.54)
(24.97)
(5)
12.84
0.21
493
Nonconstituents
19.61 ^{*}^{*}^{*}
0.83 ^{*}^{*}^{*}
0.15 ^{*}^{*}^{*}
0.12 ^{*}^{*}^{*}
0.11 * *
(51.42) ^{*}
(0.05)
(0.05)
(0.04)
(0.21)
(1.15)
(26.69)
1,335 0.40
(4)
Constituents
18.28 ^{*}^{*}^{*}
0.29 ^{*}^{*}^{*}
0.36 ^{*}
(0.01)
(0.06)
(0.05)
(0.05)
(1.54)
(0.22)
(24.98)
(3)
0.04
9.04
493 0.21
Nonconstituents
0.12 ^{*}^{*}^{*}
0.74 ^{*}^{*}^{*}
19.61 ^{*}^{*}^{*}
(46.79) ^{*}
(0.04)
(0.21)
(1.15)
(26.68)
1,335 0.40
(2)
Constituents
18.60 ^{*}^{*}^{*}
(0.05)
(1.54)
0.20 (0.21)
(0.02)
(24.98)
(1)
15.15
493 0.21
index
Return on invested capital Free cash ﬂow Growth
ﬂow aggregate net
Expected growth rate of dividend stream Aggregate net cash ﬂow
S&P 500 index fund
ﬂow
cash 500
net cash ﬂow
Observations
R ^{2}
net S&P
coefﬁcients
Adjusted
Intercept
Lagged
Lagged
fund
cash
MF
38,11
1078
Table IV. Pricetoearnings ratio regression results (March 1993February 2000)
Notes: Signiﬁcant at: ^{*} p , 0.10, ^{*} ^{*} p , 0.05 and ^{*}^{*}^{*} p , 0.01; oddnumbered columns report results from the sample of stocks in the S&P 500 index; evennumbered columns report results from the sample of stocks outside of the S&P 500 index with greater than median market capitalizations; net cash ﬂow variables are reported in billions of dollars; coefﬁcients are estimated using the ﬁxed effects model; standard errors are given below the regression
Nonconstituents
(0.25) ***
2.25 ^{*}^{*}^{*}
12.23 ^{*}^{*}^{*}
0.02 ***
0.02 ^{*}^{*}^{*}
0.03 ^{*} ^{*}
(0.01)
(0.02)
(0.00)
(0.00)
(0.02)
(0.02)
(0.09)
(1.96)
(0.00)
0.00
0.73
(8)
1,324
Constituents
0.20 ***
0.23 ***
0.02 ^{*}^{*}^{*}
3.24 ^{*}^{*}^{*}
0.01 ***
0.07 ^{*}^{*}^{*}
(0.02)
(0.00)
(0.00)
(0.02)
(0.10)
(1.58)
(0.00)
(0.01)
(0.00)
(7)
1.45
0.71
491
Nonconstituents
(0.18) ***
12.81 ^{*}^{*}^{*}
2.26 ^{*}^{*}^{*}
(0.02)
(0.02)
(0.02)
(0.00)
(0.09)
(1.97)
0.00
0.03
0.73
0.01
(6)
1,324
Constituents
0.25 ***
0.25 ***
3.26 ^{*}^{*}^{*}
0.07 ^{*}^{*}^{*}
(0.02)
(0.02)
(1.58)
(0.10)
(0.01)
(0.00)
(0.00)
(5)
1.84
0.71
491
Nonconstituents
2.29 ^{*}^{*}^{*}
12.24 ^{*}^{*}^{*}
0.04 ^{*}^{*}^{*}
0.01 ^{*} ^{*}
(0.01)
(0.00)
(0.00)
(1.97)
(0.00)
(0.09)
(0.02)
0.00
1,324 0.73
(4)
Constituents
0.05 ^{*}^{*}^{*}
0.04 ***
0.05 ^{*}^{*}^{*}
3.20 ^{*}^{*}^{*}
(0.00)
(0.00)
(0.10)
(0.01)
(0.00)
(1.60)
(0.00)
(3)
0.79
491 0.71
Nonconstituents
12.33 ^{*}^{*}^{*}
2.28 ^{*}^{*}^{*}
0.04 ^{*}^{*}^{*}
(1.97)
(0.02)
(0.09)
(0.00)
0.00
1,324 0.73
(2)
Constituents
3.30 ^{*}^{*}^{*}
(0.00)
0.00 (0.01)
(0.10)
(1.62)
(0.00)
(1)
2.44
491 0.70
index
Return on invested capital Free cash ﬂow growth
ﬂow aggregate net
Expected growth rate of dividend stream Aggregate net cash ﬂow
index fund
ﬂow
cash 500
500 ﬂow
Observations
R ^{2}
net S&P
coefﬁcients
Adjusted
Intercept
S&P cash
Lagged
Lagged
fund
cash
net
The impact
of passive
investing
1079
Table V. Pricetobook ratio regression results (March 1993February 2000)
evennumbered columns report results from the sample of stocks outside of the S&P 500 index with greater than median market capitalizations; net cash
ﬂow variables are reported in billions of dollars; coefﬁcients are estimated using the ﬁxed effects model; standard errors are given below the regression
Nonconstituents
Notes: Signiﬁcant at: ^{*} p , 0.10, ^{*} ^{*} p , 0.05 and ^{*}^{*}^{*} p , 0.01; oddnumbered columns report results from the sample of stocks in the S&P 500 index;
0.08 ^{*}^{*}^{*}
43.17 ^{*}^{*}^{*}
(0.18) * *
33.73 ^{*} ^{*}
(0.03)
(0.03)
(0.09)
(0.09)
(0.07)
(1.00)
(0.04)
(2.44)
(0.01)
(15.87)
1.29
0.03
0.33
(8)
1,164
Constituents
39.82 ^{*}^{*}^{*}
38.36 ^{*}^{*}^{*}
0.07 ^{*}^{*}^{*}
2.73 ^{*} ^{*}
0.06 ^{*} ^{*}
(0.03)
(0.03)
(0.09)
(0.09)
(1.19)
(0.05)
(2.64)
(0.06)
(10.76)
(7)
0.14
0.18
0.03
476
Nonconstituents
43.34 ^{*}^{*}^{*}
33.85 ^{*} ^{*}
(0.09)
(0.05)
(0.08)
(0.08)
(1.00)
(2.44)
(0.04)
(0.01)
(15.87)
0.33
1.25
(6)
1,164
Constituents
38.72 ^{*}^{*}^{*}
40.18 ^{*}^{*}^{*}
0.20 * *
2.73 ^{*} ^{*}
(0.08)
(0.08)
(1.19)
(2.64)
(0.05)
(0.06)
(10.76)
(5)
0.18
0.13
476
Nonconstituents
43.36 ^{*}^{*}^{*}
0.05 ^{*} ^{*}
33.72 ^{*} ^{*}
(0.03)
(0.03)
(1.00)
(0.04)
(2.44)
(0.01)
(15.87)
1.27
0.03
1,164 0.33
(4)
Constituents
38.31 ^{*}^{*}^{*}
39.68 ^{*}^{*}^{*}
^{*}^{*}^{*}
^{*}^{*}^{*}
2.74 ^{*} ^{*}
0.07 (0.02)
0.08 (0.02)
(1.19)
(0.05)
(2.64)
(0.06)
(10.76)
(3)
476 0.18
Nonconstituents
43.43 ^{*}^{*}^{*}
33.83 ^{*} ^{*}
(1.00)
(2.44)
(0.04)
(0.01)
(15.87)
1,164 0.33
1.25
(2)
Constituents
38.70 ^{*}^{*}^{*}
39.95 ^{*}^{*}^{*}
2.75 ^{*} ^{*}
(1.19)
(0.05)
(2.64)
(0.06)
(10.77)
(1)
476 0.18
index
ﬂow growth
of dividend stream Aggregate net cash ﬂow Lagged aggregate net
rate
index fund
Return on invested capital
ﬂow
Free cash growth
cash 500
500 ﬂow
Observations
R ^{2}
net S&P
coefﬁcients
cash ﬂow
Expected
Adjusted
Intercept
S&P cash
Lagged
fund
net
MF
38,11
1080
Table VI. Pricetoearnings ratio regression results (March 2000February 2007)
evennumbered columns report results from the sample of stocks outside of the S&P 500 index with greater than median market capitalizations; net cash
ﬂow variables are reported in billions of dollars, coefﬁcients are estimated using the ﬁxed effects model; standard errors are given below the regression
Nonconstituents
Notes: Signiﬁcant at: ^{*} p , 0.10, ^{*} ^{*} p , 0.05 and ^{*}^{*}^{*} p , 0.01; oddnumbered columns report results from the sample of stocks in the S&P 500 index;
(0.03) ***
0.02 ^{*}^{*}^{*}
1.01 ^{*}^{*}^{*}
5.83 ^{*}^{*}^{*}
2.21 ^{*}^{*}^{*}
0.01 ^{*}^{*}^{*}
0.02 ^{*}^{*}^{*}
(0.01)
(0.00)
(0.00)
(0.01)
(0.09)
(2.01)
(0.19)
(0.00)
0.67
0.01
(8)
1,173
Constituents
0.01 ^{*}^{*}^{*}
0.03 ^{*}^{*}^{*}
0.02 ^{*}^{*}^{*}
4.41 ^{*}^{*}^{*}
9.51 ^{*}^{*}^{*}
2.33 ^{*}^{*}^{*}
0.01 *
(0.00)
(0.01)
(0.00)
(0.00)
(0.01)
(0.23)
(0.00)
(0.12)
(0.84)
(7)
0.59
477
Nonconstituents
1.00 ^{*}^{*}^{*}
2.26 ^{*}^{*}^{*}
0.02 ^{*}^{*}^{*}
6.00 ^{*}^{*}^{*}
0.01 * *
0.01 ^{*} ^{*}
(0.01)
(0.01)
(0.19)
(2.02)
(0.09)
(0.00)
0.66
(6)
1,173
Constituents
0.04 ^{*}^{*}^{*}
0.04 ***
9.59 ^{*}^{*}^{*}
2.43 ^{*}^{*}^{*}
4.40 ^{*}^{*}^{*}
(0.01)
(0.01)
(0.00)
(0.84)
(0.23)
(0.00)
(0.12)
(5)
0.59
477
Nonconstituents
5.89 ^{*}^{*}^{*}
0.02 ^{*}^{*}^{*}
0.01 ^{*}^{*}^{*}
2.23 ^{*}^{*}^{*}
1.01 ^{*}^{*}^{*}
0.01 ^{*}^{*}^{*}
(0.00)
(0.00)
(0.19)
(0.00)
(0.09)
(2.01)
1,173 0.67
(4)
Constituents
^{*}^{*}^{*}
^{*}^{*}^{*}
9.50 ^{*}^{*}^{*}
2.28 ^{*}^{*}^{*}
4.42 ^{*}^{*}^{*}
(0.00)
0.02 (0.00)
0.02 (0.00)
(0.00)
(0.23)
(0.12)
(0.84)
(3)
477 0.59
Nonconstituents
6.01 ^{*}^{*}^{*}
1.00 ^{*}^{*}^{*}
2.26 ^{*}^{*}^{*}
0.02 ^{*}^{*}^{*}
(0.00)
(0.19)
(2.02)
(0.09)
1,173 0.66
(2)
Constituents
9.59 ^{*}^{*}^{*}
^{*}^{*}^{*}
^{*}^{*}^{*}
(0.85)
2.35 (0.23)
4.41 (0.12)
(0.00)
(0.00)
(1)
477 0.59
index
Return on invested capital Free cash ﬂow growth
Expected growth rate of dividend stream Aggregate net cash ﬂow Lagged aggregate net cash ﬂow S&P 500 index fund net cash ﬂow
ﬂow
cash 500
Observations
R ^{2}
net S&P
coefﬁcients
Adjusted
Intercept
Lagged
fund
The impact
of passive
investing
1081
Table VII. Pricetobook ratio regression results (March 2000February 2007)
MF
38,11
1082
of downwardsloping (i.e. not horizontal) demand curves for stocks and suggest that money ﬂow from index funds can distort stock prices.
B. Practical implications of research ﬁndings Based on the results from our empirical study, it appears that the preference shift towards index fund investing is reducing the informational efﬁciency of stock prices. Informed investors may recognize the oversupply of capital allocated to stocks in indices and then place trades which counteract the effect (Grossman and Stiglitz, 1980)[6]. However, the speed of adjustment back to equilibrium valuations will be slow in the presence of inattentive investors (Dufﬁe, 2010). By their nature, index fund investors are inattentive to asset valuations and, as described in De Long et al. (1990) and Shleifer and Vishny (1997), arbitragers (and perhaps most importantly those who provide them with capital) are rather impatient[7]. Prior theoretical work implies that, in the speciﬁc setting examined in this study, the preference shift towards index fund investing is an endogenous determinant of the speed of adjustment and as a result intertemporal arbitrage opportunities stemming from the shift will be unattractive. Moreover, until the preference shift abates, attempting to arbitrage the mispricing away may drown those informed traders swimming against the current of passive investment. This is because, as discussed in De Long et al. (1990), the impact of noise trader risk on asset prices is increasing in the proportion of noise traders in the market. This implies that the distortive effect of index fund investing on stock prices may be intensiﬁed by the perverse tendency of many active fund managers to “closet index” (Cremers and Petajisto, 2009). Mispricing among equities within the index may have adverse implications, including a reduction of the allocative efﬁciency of the stock market and investors’ performance evaluations of actively managed funds. The ﬂow of nonvaluation motivated passive funds may also reduce oversight among ﬁrms within the S&P 500, even if index inclusion increases the number of analysts providing information to investors about ﬁrm governance (Yu, 2008). These and other economic consequences are discussed in Wurgler (2010), Woolley and Bird (2003), Wermers and Yao (2010) and Ye (2011). This study adds to the literature on the importance of passive investing on valuations by linking ﬂows into index funds with the valuations of companies that are constituents of the index relative to those that are not.
Notes
1. See, for example, Shleifer (2000) for a discussion of this hypothesis.
2. Some advantages of PB ratio are that it provides more meaningful valuation estimates in the event that earnings are negative and book values tend to be less volatile than earnings. However, it is important to bear in mind that one downside of book value is that it does not consider human capital as an operating factor. Additionally, it is difﬁcult to compare companies in different industries based on PB ratios due to differing levels of hard asset intensity across industries.
3. Details on the methods employed by Morningstar to estimate net cash ﬂows can be found at: http://corporate.morningstar.com/us/documents/Direct/INS_MDT_ EstimatedNetFlowsMethodology.pdf
4.
Nonoperating establishments are detected through industry name. Following the method of Petersen and Rajan (1997), ﬁnancial services companies are considered to be those with
a Standard Industrial Classiﬁcation code ranging from 6,000 to 7,000. ADRs, ADSs, AMs, and GDRs are detected through the company name (i.e. – ADR in a company name indicates that the security is an ADR).
5. For a discussion of how these factors impact valuations, see Koller et al. (2005) and Damodaran (2007).
6. Alexander et al. (2007) ﬁnd that valuationmotivated trades by mutual fund managers outperform nonvaluation motivated trades, and that this outperformance was greater in the more recent period (19922003) than it had been between 19801991. The increased magnitude of the effect over a period characterized by a preference shift towards passive investing lends some credence to Grossman and Stiglitz’s (1980) theory.
7. De Long et al. (1990) suggest that this is because investors’ evaluations of professional money managers often occur over short time intervals. Gromb and Vayanos (2010) provide a detailed review of the literature on the limits of arbitrage.
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Allen,
F.
and
Myers,
S.
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MF
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1084
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Corresponding author David Nanigian can be contacted at: david.nanigian@theamericancollege.edu
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