There is no shortage of debate on the topic of index investing. (I recently contributed to this glut with a post looking at the extent of passive investing.) To some one like me who tracks these things on a daily basis I almost feel the need to drop the topic entirely out of sheer exhaustion. That being said I do want to introduce one question that arose out of a reading of some recent articles.

James Ledbetter writing at the New Yorker reviewed some recent papers that show how index investing could affect commodities, consumers and airlines. The point being that the rise of indexing is having effects outside of the markets that we still may not understand very well. Ledbetter concludes:

Given the cost-effectiveness of the strategy, individual investors will not abandon index funds any time soon. But perhaps we shouldn’t be shocked if an investment method that encourages us to use as little discernment as possible ends up being too good to be true. If passive investing continues to be one of the fastest-growing trends in finance, the concerns will not disappear, and the market may have to adapt to accommodate them.

Cullen Roche at Pragmatic Capitalism comes to the defense of index investing in part by noting that the secondary market, where all of this activity occurs, is not the economy. Since active managers have yet to show much in the way of skill or “alpha” there is little to worry about here. Roche concludes:

All in all, I don’t see the rise of indexing as being problematic for the real economy or the financial markets. In fact, I see the rise of indexing as an overwhelming positive for consumers as it creates access to liquid markets at very low costs. Importantly though, passive indexing will always rely on some degree of active investing as passive indexers pay active investors to implement their strategy for them. This incentivizes active management particularly in the form of market making and ensures that passive indexing cannot exist without an active component. Index funds and ETFs are some of the greatest financial innovations of the last 50 years.³ Don’t let anyone fool you otherwise.

A recent paper by Dimitri Vayanos and Paul Woolley entitled “Curse of the Benchmarks” argues that investment trustees are doing themselves a disservice by contracting managers to portfolios that closely track well-known benchmarks. They argue that these mindless flows tend to create market inefficiencies like the momentum and low-vol effect. In short, the ultimate end-investors are creating their own problems. They write:

The charge sheet against benchmarking and momentum, is a long one. Together they cause mispricing across the spectrum of asset markets, notably the inversion of risk and return, bubbles and crashes, and secular over-valuation. They lead to the misallocation of capital at the micro level, and crises and contraction in the macro-economy. The implication is that much of the activity in asset management and security markets is not merely superfluous but wealth-destroying. This is not surprising given that the majority of trades bear no relation to fundamental worth and are focussed instead on window-dressing and gaming. The remedy lies in changing incentives, not in a barrage of regulation, and starts with an understanding of the strategy options facing investors.

I would agree with Roche that index funds, and their offspring ETFs, have been a boon to investors. The savings in fees and the downward pressure they exert on active managers is worth celebrating. It’s one thing to recommend index funds to an individual investor, it’s another thing altogether to say that indexing has no ill-effects on the capital markets and economy as a whole. There could come a day when index investing created obvious market mispricings. Which leaves us with a conundrum: is indexing micro-efficient and macro-inefficient? In short, are we turning a blind eye to potential problems in favor or essentially-free index funds?