Addressing Some Misconceptions about Indexing

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While Forbes magazine has often carried excellent articles about investing such as this one, we found a recent column from Pamela Rosenau to be disappointing. She begins by noting the mass migration from active management to passive and quotes Jack Bogle who said, “About $800 billion has gone out of actively managed funds, and about $1.2 trillion has gone into index funds over the past six or seven years. That is, roughly, a $2 trillion swing in investor preferences.” Rosenau partially attributes this shift to a response by investors who got burned during the financial crisis, and she essentially declares it to be nothing new under the sun, even going so far as to say that Bogle’s starting of the first retail index fund in 1975 after the severe bear market of 1973-74 was no coincidence. She asserts that indexing does well in bull markets like the one we have had since March of 2009, but she foresees some potential problems:

“As passive index funds and exchange-traded funds (ETFs) continue to grow in scale, performance may suffer from the law of ‘large numbers.’ In fact, Vanguard is the top institutional holder in nine of the top ten constituents of the S&P 500. If everyone were to invest in index funds, who will be the marginal buyer? I believe the 'large number' constraint, which has plagued active managers throughout history, will soon be a headwind for passive investors. Additionally, the liquidity that had helped stimulate the market is rapidly turning into volatility. In other words, what was a straight road is becoming an increasingly winding road for market participants. Passive investing lacks disciplined risk management.”

The fact that Rosenau put large numbers in quotes clearly indicates that she was not attempting to literally apply the Law of Large Numbers which states that the average of the results obtained from a large number of trials approaches the true average as the number of trials increases. Instead, she appears to be saying something similar to what James B. Stewart said about Apple a couple of years ago in this New York Times column—namely that its size would be an impediment to future growth. Her reasoning appears to be that if index funds have too much money (i.e., if everyone were to invest in index funds), then they will have exhausted all their opportunities to earn profits for their investors. This is another way of saying that with too much indexing, the market would become inefficient and thereby destroy the value of indexing. Interestingly, one of our heroes, Charles Ellis, recently addressed1 this question in a Financial Analysts Journal article:

“Assuming that NYSE daily turnover continues at over 100% of listed shares, and index funds average 5% annual turnover, if indexing rose to represent 50% of total equity assets (from about 10% today), the trading activities of index funds would involve less than 3% of total trading. Even if 80% of assets were indexed, indexing would represent less than 5% of total trading. It is hard to believe that even this large hypothetical change would make a substantial difference to the price discovery success of active managers, who would still be doing well over 90% of the trading volume.”

In other words, we have a long way to go before the rise of indexing causes the market to become inefficient enough to make active management a worthwhile endeavor.

Regarding Rosenau’s question of who will be the marginal buyer, she is referring to a concept from economics that is more relevant to the costs of goods and services. The marginal buyer is the buyer who values the good or service exactly at its price (or just slightly above it). However, the whole point of index funds is to get the return of the market (or a specific segment of it) at a low cost. Most investors with a long-term time horizon and good information (e.g., access to the many studies supporting passive investing) will value indexing above active management.

Lastly, to address Rosenau’s assertion that passive investing lacks disciplined risk management, we believe that description far more appropriately applies to active management. For example, we have seen actively managed bond funds drift into equities in an attempt to increase their yields. Yes, a market index fund will take the full hit in a bear market, but actively managed funds have not fared better, as we discussed here. A well-guided passive investor should know how much risk she wants to have in her portfolio and will actively ensure that her portfolio stays within those guidelines, regardless of what the market does.

If you would like to learn more about how Index Fund Advisors can build a portfolio matched to your Risk Capacity, please call us at 888-643-3133.

1Ellis, Charles D. 2014. “The Rise and Fall of Performance Investing”, Financial Analysts Journal, vol. 70, no. 4 (july/August):14-23.