Passive Flows and Company Valuations: A Study of the Swedish Market

Sammanfattning: This paper analyzes the relationship between index fund flows and the valuations of index constituents listed on the Stockholm Stock Exchange. Using data on the OMXS30 and OMXS30NEXT indices, we run panel regressions of P/E ratios on index fund flows and a set of control variables. Using monthly data, we find a positive contemporaneous correlation between these flows and P/E ratios of OMXS30 companies. At mean values, the aggregate index fund flows correspond to a 1.22% increase in the valuations of OMXS30 constituents. Further, this relationship appears to be limited to the larger market capitalization names on the index. For the OMXS30NEXT, no such correlation is found on the full sample of constituents, but we do find a positive relationship between P/E ratios and concurrent index fund flows on the larger market capitalization companies of this index. Our results also show a significant interaction effect between liquidity and fund flows, indicating that this relationship is stronger for less liquid companies. While the significant positive relationship between P/E and flows may be explained by either feedback trading or a demand driven valuation effect, our results suggest evidence for the latter. Finally, the results suggest that this effect is permanent as we do not find evidence of price reversals, thus providing support of the imperfect substitutes hypothesis.