October 19, 2016
Can Index Funds Become Too Popular?
Once Upon a Time…
When we started an investment advisory firm in 1991, it seemed obvious to Bob Ryan and me that structuring portfolios by focusing on asset allocation was superior to the stock picking culture of the day. The ability to implement the strategy with low-cost index funds was still a new innovation, and we found ourselves talking with incredulous institutional investors who could not understand why any prudent, sophisticated investor would settle for market returns when every active manager walking through their door had consistently outperformed the market – at least that’s what their presentations declared.
We occasionally mused about what would happen when investors “saw the light” and embraced low-cost passive or market tracking strategies. If everyone bought index funds, could markets become inefficient and create opportunities for smart investors to beat the market by picking undervalued securities? Our conclusion – it might be possible in theory, but extremely unlikely. As the market approached a 100% devotion to index funds, capitalism would prevail and a few smart investors would start bidding up the price of undervalued securities, keeping markets reasonably efficient for everyone else.
This brings us to the latest round of arguments in the ongoing active versus passive debate. A sell-side group at Alliance Bernstein put together a provocative research piece likening a market dominated by passive investments to Marxism. The argument is that markets influence the judicious allocation of capital by determining which companies deserve investment and which borrowers deserve capital (from bonds). Index funds, by buying everything in the index according to market weight, are not contributing to the process of capital allocation, thus they are not only worse than a free-market, they are even worse than communism, where there is at least some attempt at planning and prioritizing.
How Many Active Investors Does It Take…
Somewhere around 30-35% of investable assets are now held by market tracking Exchange Traded Funds (ETFs) and mutual funds. The argument that smart money managers can outperform the market has been overwhelmed by data suggesting otherwise. Although stock pickers will not be extinct any time soon, there is a steady flow of assets moving out of actively managed mutual funds and moving into index and market tracking funds and ETFs.
As this trend continues the discussion has begun to shift to the perils of a market dominated by indiscriminate investors blindly buying market weighted index funds, but not everyone agrees with the dangers described by the Alliance Bernstein piece. Vanguard founder John Bogle (who launched the world’s first public index fund) has estimated that a 90% passive market should be sustainable. Burton Malkiel, author of the classic, “A Random Walk Down Wall Street,” has set the number even higher, at 95%, saying with indexing at 30-35% of the total, there are still plenty of active managers out there to make sure that information gets reflected quickly. “And in fact I think it’ll always be the case.”
At Rockbridge we agree with Bogle and Malkiel, that indexing is unlikely to ever reach levels where it threatens the efficiency of markets and their ability to incorporate all available information in the setting of prices. Taking advantage of market efficiency, and the availability of low-cost, evidence-based market tracking funds and ETFs, is still the best way to implement an asset allocation strategy for long-term investors.