Baked in the Cake

Q&A with IFA: Do Index Funds Contribute to Mispricing?

Baked in the Cake

Question: Index funds buy stocks "blind" without regard to company fundamentals. Do their activities contribute to mispricing of securities?

Note: The question above was originally addressed in DFA’s Fama/French Forum. Professor Fama gave his typical terse but to the point response:

“Index funds typically buy cap-weighted portfolios so they do not contribute to mispricing.”

Professor French, on the other hand, gave a more detailed response that began by noting that since index fund investors who hold a market portfolio are not overweighting or underweighting any securities, they do not affect relative prices. Next, French asks the question if prices would be more accurate if the indexers decided to abandon indexing. Of course, that depends on what they decide to do instead. If they were to simply make guesses at which securities are underpriced or overpriced based on a mistaken belief that they possess unique knowledge, then they would end up making prices less accurate. On the other hand, if they were to engage in genuine fundamental analysis, their attempt to beat the market will improve the accuracy of prices. French is quick to point out that this does not imply that switching from passive to active was a good investment decision: “Because of the higher fees and expenses of active investing, most of the formerly passive investors would have been better off with their index portfolios.

Indeed, Professor French can speak with authority about the cost of active investing, as he delivered a Presidential Address to the American Finance Association and published an article on that very subject. Based on 27 years of market data from 1980 to 2006, French concluded that investors waste 0.67% of the aggregate value of the market each year searching for superior returns. Although 0.67% may not sound like much, when we apply it to global market capitalization of $44.1 trillion (as of 7/31/2014), we get a number just under $300 billion—a staggering amount of money by any measure.

Returning to the question above, it is not a new one, and with the continued migration from active to passive, we hear it asked with increasing frequency. Sometimes, we even hear it as a complaint. Last year, for example, we published this response to a ridiculous article that claimed index funds were “parasitic” and would “kill the market”.  With the Dow closing above 17,000 and the S&P 500 crossing 2,000 for the first time (as of 9:00am on 8/25/14), Mr. Market seems quite alive and well, thank you very much.

If you would like to learn more about indexing and how it can provide you a better investment experience, please give us a call at 888-643-3133.