By Richard A Brealey, special adviser to the Governor on financial stability issues.
In recent years, many UK investors have given up the quest for superior performance and have instead simply sought to match the returns on some broad market index. This has led to the suggestion that the growth in index funds has depressed the stock prices of those companies that are not represented in the index and has thereby increased their cost of capital. This effect may have been accentuated by the actions of fund managers, whose performance is compared with that of a market index and so who also have an incentive to avoid those stocks that are not included in the index. This paper argues that, in practice, these price effects are likely to be very small. In support of this view, the paper examines the price adjustments that occur when a stock is added to, or removed from, a stock market index.