Old Upset

Index Funds are Parasitic? That's a New One!

Old Upset

Index funds have been called many things over the years: "un-American," "stupid," "unsophisticated," and NOW… "parasitic."

A recent article entitled, "Index funds are parasites and are going to kill the market" from CountingPips.com[1] commented on the increasingly popular use of index funds and its ramifications on the capital markets as a whole. Specifically, it stated, "the whole market structure is creaking...when a stock is added to an index, its price action detaches from the rest of the market and it ‘begins to move closely with its new 499 neighbors." In other words, index funds are causing stocks to become more correlated with one another. Referring to legendary Legg Mason money manager Bill Miller, the author proclaims, "the delicious irony is that this creates an environment where large cap active fund managers can no longer harvest their expected returns from value situations. We've seen many great investors, even legends like Bill Miller, lose their way in recent years." While empirical evidence suggests that investors are currently experiencing a high correlation stock environment[2], it should only be seen as a mere scapegoat in explaining the underperformance of active money managers.

Correlation describes how well a group of variables move together. A high absolute correlation indicates a strong relationship between the movement of one variable and the movement of another variable, or a group of variables. A more telling data point is the dispersion among individual stocks in an index. Dispersion measures the range of returns around the mean, i.e. the differences in magnitude of movements by individual stocks. It would seem that a wider dispersion around the mean would give active managers a better opportunity to outperform the index. Further, the use of short selling could amplify an active manager's results by "shorting" those securities that the manager believes will underperform the overall benchmark relative to their peers. The two charts below show the dispersion of the individual stock returns that make up the S&P 500 for 2011 and 2012.

As you can see, the dispersion among the individual stocks in the index is significant for both years. On average, over 60% of the individual equities lied beyond plus or minus 10% of the index return, which is ample room for active managers to display their "skill." Unfortunately, the vast majority of active money managers continue to underperform their benchmarks[3], even over relatively short periods of time where the probability of outperforming is higher just by random chance alone. In 2012, the average US Large Blend fund underperformed the index by roughly 0.90%. 

The author also mentions that index funds are "piggybacking on the coattails of the active management community," where the active managers bear the cost of price formation while the passive manager reaps most of the awards. To a certain extent, this allegation is true. Passive investors accept prices as being fair and do not incur the brunt of the costs associated with the price formation process. The author also suggests that justice would be better served if "index funds would pay a tax to the active management community for their service." This seems to be a stretch. I am sure that active money managers are taking home plenty of peoples' hard earned dollars year after year. If we want to follow the author's logic, I would suggest that a large portion of the active management community pay a tax back to their clients for their disservice to the community.

Trying to point to correlation among equities as the reason for recent active management underperformance is a myth. Although equities are more correlated now than they were 10 years ago, the dispersion among equities is wide enough to accommodate a truly gifted stock picker, if there were such a person. Further, the so-called "piggybacking" of the passive investor community seems to be actually adding more value to peoples' portfolios year after year.

There is nothing parasitic about that!

[1] "Index Funds are Parasites and are Going to Kill the Market." CountingPips.com.  March 15, 2013.

[2] Dickson, Joel M. Ph.D & James J. Rowley, CFA. "Dispersion! Not Correlation!" Vanguard. May 2012.

[3] See SPIVA report from Standard & Poors