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During the amazing bull market of the 1990s, an investment strategy of simply mimicking the Standard & Poor’s 500 Index became popular. The S&P 500 is a value-weighted market index of 500 common stocks thought to measure overall movement in the aggregate stock market. Under this investment strategy, the amount invested in each stock is proportionate to each component’s share of the total market valuation of all 500 companies. If the largest component, ExxonMobil, accounts for roughly3.4 % of the index, and the second largest component, GE, accounts for roughly 2.8 %, index followers simply invest 3.4 % of their portfolio in ExxonMobil, 2.8 % in GE, and so on. A. Explain how the stock market’s ability to discipline the managers of underperforming firms could be reduced if all investors simply purchased index funds that mimicked the S&P 500. B. Explain how institutional investors, even those with index funds, actually discipline the managers of underperforming firms in practice.
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