Who’s Afraid of Index Funds?
If passive investing creates market distortions, active managers can win big.
Challenges to the status quo—political, economic or social—always evoke strong emotions, from enthusiastic support to fierce criticism. The loudest critics often have the most to lose, even if they acknowledge some benefits of the new regime.
This clash is now unfolding over ascendant investment vehicles: index and exchange-traded funds, or ETFs. The dramatic growth of such products has been revolutionary. More investors are choosing indexing over funds managed by traditional stock pickers, known in the industry as active managers. Since 2009, U.S. index funds have seen inflows of some $1.7 trillion, compared with outflows of nearly $1 trillion for actively managed mutual funds.
Indexing has democratized investing. Today, all Americans can inexpensively and conveniently invest in markets, countries and strategies once open only to institutional investors. Yet a few detractors have compared such passive investing to Marxism and declared it an existential threat to the modern securities market. What exactly do they object to?
As more individuals and institutions invest in index products rather than individual stocks, critics claim, the price of these securities becomes increasingly untethered from the value of individual companies. They argue that companies included in these indexes see their stock prices fly higher and higher regardless of their performance, while non-indexed stocks get ignored like wallflowers at a dance.
But the numbers tell a different story. Despite the popularity of indexing, active managers still dominate the buying and selling of stocks. Indexed assets—including mutual funds, ETFs and institutional portfolios—account for less than 20% of all global equities, according to our analysis. That’s about $12 trillion of a $68 trillion market. The rest is actively managed. Those actively managed assets trying to beat the market trade much more frequently than indexed assets do. At BlackRock, we estimate that for every $1 of U.S. stock trades driven by investors buying or selling index funds, there are $22 of trades driven by active stock pickers. Combine the effects of greater size and faster turnover, and it’s clear that the price of stocks is overwhelmingly determined by active traders.
Critics of indexing sometimes point to the specter of a 100% indexed market. What would happen, they ask, if indexing replaced stock-picking entirely? Naturally, this would make it impossible to price individual securities properly. But this hypothetical ignores the natural equilibrium created by supply and demand. If indexing began to distort stock prices, that would create an enormous opportunity for active fund managers to reap big returns—attracting more dollars to those active funds and at least partly reversing the flow toward index management. This process is why active management remains—and will continue to remain—essential.
Indexing is only one component of a diverse, robust and constantly innovating ecosystem. Think of ETFs and index funds as levers that sit alongside individual stocks and bonds, actively managed funds, futures and swaps, private equity and IPOs. Together, they combine to support the smooth functioning of U.S. capital markets and Americans’ ability to confidently buy and sell securities. What cannot be disputed is that indexing’s success has upended the status quo. The effect will grow as regulatory regimes around the world require the kind of consumer-friendly price transparency that benefits index products.
To be sure, there are still questions to address. For example, investors need to better understand the difference between plain-vanilla ETFs and highly leveraged exchange traded notes, or ETNs, which have more volatile prices. But while debate is healthy, it needs to be based on facts rather than fear. There is a big difference between disruptions to the way traditional asset managers do business, which certainly are occurring, and disruptions to the basic functioning of capital markets, which are not.
Far from undermining the markets, indexing has unleashed new competition, driven innovation and identified new ways to deliver profits. Even active managers are using more ETFs, while everyday investors are saving more. The rise of indexing has changed for the better the way all investors seek returns, manage risk and build portfolios. That’s a development everyone should welcome.
This article originally appeared in The Wall Street Journal, November 26, 2017. Please click here to read the original article.