Sinking Ship

Is Indexing the End of Capitalism? We Don't Think So!

Sinking Ship

Political commentator Jonathan Russo wrote an interesting article on called “Indexing and the End of Capitalism.” Although it had a great start by noting the arrival of the tipping point for passive over active, it unfortunately went downhill from there. After describing Marx’s vision of capitalism sowing the seeds of its own destruction, Russo claims that index funds are one of these seeds. Specifically, Russo makes the following outrageous supposition:

“Karl Marx never met an index fund. If he had he would have added this phenomenon to his list of capitalism-destroying mechanisms. How so? While it is probably true that via backtesting of investment results, ninety percent of fund managers cannot beat the passive indexes, it is also possibly true that the seeds of economic decline lie in the attempt to right this wrong.”

While we are delighted that Russo acknowledges the failure of active management, his argument that investors acting to counteract this failure will lead to “economic decline” is ill-founded. Russo paints the most extreme picture possible of all investors indexing with nobody attempting to engage in price discovery. It is a world where the only goal of a company is to be listed in an index, after which it need not worry about cash flows, profits, dividends, etc. Quite simply, this will never happen. In a recent Financial Analysts Journal article1, Charles Ellis addressed the question of what the minimum percentage of market participants that need to be engaged in price discovery for the market to be efficient to the degree such that a dollar spent on active management is unlikely to return more than a dollar back?

“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 anywhere near to the degree envisioned by Russo.

Russo drags out the tired argument that indexing rewards bad behavior (e.g., Enron) by forcing investors to supply capital to companies that don’t deserve it. He overlooks the fact that active investors supply capital to these companies in exactly the same proportion as indexers. He also claims that indexing will mean the end of socially responsible investing. As investment advisors who often recommend index funds that are either socially responsible or geared to environmental sustainability, we beg to differ.     

Russo closes by stating that he can hear Karl Marx laughing from his grave. Yes, he is probably laughing at the fact that so many active managers get paid so much for adding so little value. One of the pioneers of indexing, Rex Sinquefield, pointed out that the few remaining disciples of Marx do indeed have something in common with active managers:

“So who still believes markets don’t work? Apparently, it is only the North Koreans, the Cubans and the active managers.”

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