Abnormal Returns is on a bit of a respite this week. That does not mean that we are content-free. As we have done in previous years we asked a panel of highly respected independent finance bloggers a series of (hopefully) provocative questions. Below you can see the blogger’s name, blog name and Twitter/StockTwits handle. We hope you enjoy these posts as much as we do. Feel free to jump in the comments with your own answers to the questions.
Question: Like just about every other blogger I have been writing on the rise on index investing. Should we care that the percentage of assets in indexes is on the rise, or should we just sit back and enjoy the (low cost) ride? (Answers in no particular order.)
There might be a theoretical limit to how much money can be passively invested, but of course definitions of “passive” differ. Even so, we aren’t anywhere near being close to such a limit. The relentless math of active management means that 50% of strategies have to underperform the average, regardless of how much money is indexed. I’m inclined to agree with Larry Swedroe that fewer active managers may actually make the opportunity set for surviving active strategies more difficult, not simpler. Fewer individuals trading stocks can mean fewer inefficiencies to take advantage of.
I think that the rise of index investing is a good thing overall for most investors. ETFs have helped illuminate the way forward and smart beta is helping people realize that there are other avenues of indexing rather than just market cap weighting.
To me there are parallels to the prisoner’s dilemma in that passive investing is a rational choice for most taxable investors, but potentially poor for the economy as a whole. In terms of the impact on market efficiency, I have begun to question my initial view that it was bad due to a question recently raised by @3rdmoment as to whether the marginal investor that has shifted from active to passive has been smart or dumb money? If dumb money, perhaps market efficiency actually improves (though I question whether someone who understands the benefit of passive is dumb money).
The impact I am more concerned with is in the concentration of assets into less and less differentiated products and the fact that ETFs have become a liquidity provider (when flows are positive) in areas of the market that are illiquid. The largest ETFs continue to gain share (given scale matters greatly in the passive world), which raises a concern of what will happen when flows eventually leave these funds (as they always do), while the liquidity mismatch has largely been untested since it has become such a large percent of the market.
One of the reasons why correlations are rising. This should lead to more excesses and opportunities for active managers over time.
I heard a joke about this recently:
Q: How many investors does it take to keep the markets efficient?
A: Two dentists having lunch in Lubbock.
This is obviously an exaggeration but the zero-sum nature of active management remains. Indexing zealots seem to think the increased fund flows it don’t matter while many hardcore active investors assume that indexing is ruining the markets. As with most things, there’s probably some truth to each argument but not to the extremes that these groups believe. Both active and index investing serve a purpose and they need each other to survive. The amount of money pouring into index funds has to have some effect on the markets, but the question is how much. There have always been closet index funds. Is the money coming from those funds or elsewhere? Is it mostly “dumb money” coming out of active or is it the “smart money”? If it’s mostly dumb money then there are actually fewer opportunities in the markets to take advantage of people. I subscribe to the theory that too much indexing will likely lead to a mostly micro-efficient but macro-inefficient market where there is more volatility and bigger swings in valuations. However, I don’t know what that level would be. For the most part index funds are a very good thing for investors, but it really depends how they’re used. It doesn’t matter what your costs are if you can’t sit still and follow a long-term plan.
Enjoy the low cost ride and appreciate that the index investors don’t exacerbate highs and lows.
Index investing has certainly pushed down the fees associated with investing in the stock market. It has also given the average individual investor an easier “jump into the pool” option to get started with investing. Since you don’t have to devote time and energy to researching various mutual fund families, investment managers, or individual stocks, index funds let passive investors get exposure to broader market returns with a low-fuss strategy.
Most investors (professional and non) significantly underperform the market, a fact that has given rise to one of the most popular arguments in favor of passive index investing. “If you can’t beat ’em, join ’em”. Arguments against passive investing include a) the notion that indexing is a “socialist” investing process which favors big incumbents over smaller, dynamic growth companies and subverts true price discovery in asset markets b) the much-touted “diversification” of index funds won’t really save you when your index of choice falls 40-50% in a rough bear market, as has happened twice in the last 16 years.
I don’t write much about indexing. I also don’t write much about breathing, and other things that we don’t have to think about in order for it to happen. Active management ultimately benefits from indexing, because less of the money in the market looks for fundamental value. Indexing benefits from active management because prices are roughly in line – you can be a free rider on the wisdom of others.
I like to use hyperbole to make a point. If 99% of all assets were indexed then the 1% of assets being actively managed could pick off the indexers. The more money goes into indexing (or any other type of investing), the less attractive the returns will be in that style, creating opportunities for everyone else.
Enjoy the ride. And know that the cure for “too much indexing” is already in progress in the form of a flat, choppy market that rises and falls but ultimately goes nowhere, which is the story of the MSCI All Country World Index heading into its third year of nothing. A few more and you’ll see a lot of the enthusiasm for low cost, passive dim.
The only people who need to worry about the rise of indexing are those who, for many years, have earned a very comfortable living from selling and promoting overpriced and overhyped products that consistently fail to deliver.
We’re seeing all manner of scare stories put about by the vested interests who stand to lose from the growth of indexing, most of which are frankly laughable. Is it bad for the economy, or for enterprise? Of course not. 99% of what active managers do is trade with one another. Are we seeing an indexing bubble? Again, that’s ridiculous. As Ben Carlson recently pointed out, we’ve had a closet indexing bubble for more than 30 years now, and it doesn’t seem to have had a detrimental impact on market efficiency. Besides, indexing is still, relatively speaking, a very small part of the investing universe.
So no, don’t worry about the growth of low-cost investing. Let’s enjoy it. Come on in — the water’s lovely.
Indexing requires active management in order to maintain the “passive” allocation held by the indexers. The rise of indexing is good for both the technologically enabled active market makers and arbitrageurs as well as the passive indexers. It is, however, very bad for the high fee traditional “active” manager.
Vanguard and passive investing have been a boon to the broader investment community, since, in general, these approaches offer superior after-cost, after-tax returns, versus overpriced, tax-inefficient, active (or closet-index) mutual funds. So most people should indeed, “Sit back and enjoy the low cost ride.” Passive investing, and the increased level of transparency, are ideas the financial services industry should embrace.
But as you have discussed in your own writings, there has been some debate around whether, if more and more of the market invests passively, this might create systemic problems. For example, stocks that sit in large indexes can become more correlated and move together, despite fundamentals. We all remember from the financial crisis how correlations can “go to one,” with all risk assets moving together with the fluctuations in the overall market. If true, then traditional notions of diversification may need to be rethought in this light. Also, active investors can exploit fund flow information and take advantage of “dumb money” coming into and out of stocks that make up large indexes. Finally, with too much passive, and not enough active, asset prices might move further away from intrinsic value, on average. For passive investors that buy and hold forever, this may not matter, but for passive investors that need to reinvest their dividends, sell assets for liquidity reasons, etc., they will necessarily be exposed to “fleecing” by active investors. Bottom line: passive investors need to be careful that they don’t enjoy too much of a good thing. Passive investing free rides on the efforts of active investors, and if active investors get tired of “the free ride” it is likely that the passive investors will be the ones who pay the final bill. I’m not sure we are even close to the market equilibrium where passive becomes such a large portion of total assets that their free-riding efforts destroy market efficiency, but it is certainly an interesting thing to consider.
For firms that can actually do original work that adds value, the increasing share in indexed vehicles should increase opportunities over time. Momentum strategies of certain types might work, but a value-based approach with a long time horizon will be the best at taking advantage of the distortions created by the momentum concentrations triggered by heavy index investing.
At some point, this will end badly. Indexing only works as a winning strategy when there are enough active managers to make the market at least quasi efficient. If everyone indexes and no one bothers to do fundamental research anymore, the conditions that made indexing work will no longer be in place.
Furthermore, Bill Ackman touched on something recently that was spot on. Index investors and their managers generally don’t bother to vote proxies. They are true passive investors. At some point, that becomes a problem because it erodes corporate governance. Lousy management teams stay in control because there is no one to vote them out and kick them to the curb.
I suppose the takeaway here is that nothing in finance is certain or permanent. There is no “end of history” here. The index trend will continue until it reaches true excess, and then it will effectively break down. What replaces it? Traditional active management? Something new we haven’t even thought of yet? Who knows. I suppose we’ll find out soon enough.
No, I’m not worried about the rise of indexing. The investment world loves to find things to be “concerned” about. Indexing is a great benefit for investors. I find the efficient versus inefficient debate to be pretty tedious. If you’re willing to accept what the market does, then indexing is a fine strategy. Still, with a little work, you can do better.
30-years after the founding of Vanguard and about 25% of the market is passively indexed. I don’t know where the top end is, but most of the believers have converted at this point. I don’t think there’s a big risk of concentration or dislocations. An extreme corollary is energy ETFs becoming large factors in the energy futures market — they’re mostly passively long oil futures. As we’ve seen recently, the existence of these passive players has not impeded price discovery to the downside. Passive investors get spooked and sell just like everyone else.
Those who do not pick their own stocks must add value through sector choices and asset allocation. For those approaches, the index funds are great. I am troubled that many of the entries seem to depart from NAV during the day. I do use some index ETFs, but I emphasize places where I want exposure and the individual stock data is unreliable.
I don’t care and see no reason to care.
We should sit back and enjoy the ride. Bogle recently said with Barry Ritholtz that it would take years and years for indexes to amount to half of the market. I’m with him and I don’t think it ever gets there.
Thanks to everyone for their participation. You can also check out yesterday’s edition as well. Stay tuned for another question tomorrow.