Indexing Fuss Unwarranted
Passive investing has been ridiculed by Wall Street for decades. The following list is just a small sample of the criticisms I’ve collected over the years:
- Sanford C. Bernstein & Co. strategist Inigo Fraser-Jenkins called it worse than Marxism.
- David Smith, fund manager at Hargreaves Lansdown, called passive investors parasites on the financial system.
- Tim O’Neill, global co-head of Goldman Sachs’ investment management division, warned investors that if passive investing gets too big, the market won't function.
The common theme is that indexing (and passive investing in general) has become such a force that the market’s price discovery function is no longer working properly. Goldman Sachs’ O’Neill has even called passive investing a “potential bubble machine.”
Given the number of questions I get from investors about this issue, one would think that passive investing is now dominating markets. Let’s see if there’s any truth to such beliefs, and whether there’s anything to worry about.
A recent study by Vanguard found that, as of October 2017, about $10 trillion was invested in index funds. While a large figure, it represents less than 20% of the global equity market. Is there anyone who thinks the other 80% of assets are handicapped in their price discovery efforts? Even more important is that, while indexing makes up about 20% of invested assets, Vanguard estimated it actually accounts for only about 5% of trading volume. Is passive investing’s 5% share of trading volume setting prices, or is it active management’s 95% share doing so? Once you know the data, you can see how absurd the claims being made are.
While it’s certainly possible that, at some point, passive investing could reach such a dominant share that price discovery would be limited, clearly, we are nowhere near that level, and almost certainly won’t be there for a very long time.
Another Important Point
It wasn’t until 1950 when the number of mutual funds topped 100. That number was still only at about 150 in 1960. And hedge funds were a nascent industry. Today we have about 9,000 mutual funds and 10,000 hedge funds. Twenty years ago, hedge funds controlled about $300 billion. Today that figure is 10 times as large. Essentially, Wall Street wants you to believe that, while 60 years ago the markets were operating efficiently with only about 100 actively managed funds, the markets are no longer functioning well when we have close to 20,000 active funds.
All this criticism isn’t based on any facts. Instead, it is the result of investors waking up to active managers’ failure to add value and thus abandoning active strategies in favor of passive ones. For example, 2017 was the fourth-straight year money flowed into passive funds and out of active funds. The active industry has to fight back in an effort to at least slow the tide. That said, it’s important to note active investors have an important role to play. Thus, we don’t want them to disappear entirely.
Benefits Provided By Active Investors
Active managers play an important societal role. Specifically, their actions determine security prices, which in turn determine how capital is allocated. And it is the competition for information that keeps markets highly efficient, both in terms of information and capital allocation.
Passive investors are “free riders.” They receive all the benefits from the role that active managers play in making the financial markets efficient without having to pay their costs. In other words, while the prudent strategy is to be a passive investor, you don’t want everyone to draw that conclusion. Passive investors need hope to spring eternal for those still convinced active management is the winning strategy.
However, there’s another question to consider, and it involves the costs that accompany the societal benefits active managers provide.
Cost of Active Management
Kenneth French sought to address that important issue in his 2008 study, “The Cost of Active Investing.” His study covered the period 1980 through 2006, and included mutual funds, ETFs, hedge funds and institutional funds. By comparing the fees, expenses and trading costs that society pays to invest in the U.S. stock market with an estimate of what it would pay if everyone invested passively, French found that investors spent 0.67% of the market’s aggregate value each year searching for superior returns.
French concluded that active investors are engaged in a massive transfer of wealth (about $80 billion annually, based on a market capitalization at the time of about $12 trillion) from their own wallets and into the hands of the purveyors of actively managed products. Today that figure is likely much higher, as total U.S. stock market capitalization is now about $30 trillion.
Worth The Costs?
Given the magnitude of the wealth transfer French describes in his research, it’s hard to make the case that investors and the country as a whole wouldn’t be better off if much, but not all, of the active management industry disappeared.
As Andrew Berkin, and I point out in our book, “The Incredible Shrinking Alpha,” the percentage of active managers able to generate statistically significant alpha has fallen from about 20% 20 years ago to just 2% today.
While it seems clear that the trend toward passive investing isn’t having a major impact on the price discovery function, that doesn’t mean indexing isn’t having any influence on prices.
For example, it has long been known that, when stocks are added/subtracted from indexes, there is an immediate impact on prices due to forced trading by index funds and the actions of active managers who anticipate those forced trades. In addition, stocks added to the S&P 500 Index not only get a boost in valuation upon their addition, but tend to stay at that elevated valuation relative to comparable securities.
Well-designed, passively managed funds avoid these impacts by accepting tracking error risk to the benchmark—while all index funds are passively managed, not all passively managed funds are index funds. It’s one reason why, at my firm, Buckingham Strategic Wealth, while we only use passively managed funds in client portfolios, we generally avoid the use of pure index funds.
While no one knows exactly how many active institutional managers are needed to keep markets functioning well, it’s almost certainly a fraction of the size of today’s industry. As I noted above, 60 years ago, when the mutual fund and hedge fund industries were a small percentage of their size today, markets worked well in terms of setting prices and allocating capital. Thus, there is no reason to believe it would not do so again if the active industry shrunk. I believe investors certainly would be far better off.