Most Arguments Against Index Investing Aren’t Compelling (Part 1)

Efficiency and dislocations?

Alex Bryan 30.10.2019
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There’s a lot to like about index investing. Market-cap-weighted index funds harness the market’s collective wisdom, they tend to enjoy a sizable cost advantage over their active counterparts, and they avoid key-person risk. They’ve put downward pressure on fees across the entire asset-management industry, which has also helped investors in actively managed funds. But not everyone is a fan. Here’s a closer look at some arguments against index funds. Most aren’t compelling.

1 | The market isn’t perfectly efficient, which creates opportunities for active investors.

Market efficiency is the idea that prices reflect all publicly available information. If it’s true, funda­mental research shouldn’t help active managers—after adjusting for risk—beat the market. Clearly, the market doesn’t always get prices right. But that doesn’t mean the market is easy to beat. Indeed, most active managers don’t.

The market efficiency argument says more about the risk of manager selection than it does about the case for index investing. In aggregate, active investors hold the same portfolio as passive investors, as broad, market-cap-weighted funds just replicate the composition of the market. So, their performance should be similar gross of fees. But because passive funds tend to charge less, they should do better on average. That’s true regardless of market efficiency. If market inefficiency helps some investors, it hurts others. Paradoxically, as market efficiency declines, the case for index investing becomes stronger for uninformed investors because the risk of manager selection increases. There’s a wider range of potential returns, both good and bad.

Even if a lack of market efficiency isn’t necessarily bad for index investors, it could result in less-efficient capital allocation for the economy and create opportunities for skilled active investors to exploit. So, it still matters.

Yet it is tough to identify mispriced securities because competition among investors is fierce and they can all access the same information, with sufficient resources. Even when an active investor does correctly identify such securities, there’s no risk-free way to benefit from mispricing. Stocks that look cheap can always become cheaper before they become fully valued. Even if the manager is ultimately right, inves­tors may lose patience and pull their money from the fund before prices converge to fair value, forcing the manager to sell out prematurely.

2 | As indexing becomes more popular, there is a risk that the market could become less efficient.

This argument suggests that index investing itself makes the market less efficient. At first blush, it seems plausible. As more investors shift from active to passive funds, there is a decline in resources dedi­cated to determining what each security is worth, which could lead to greater and more common devia­tions from fair value.

I once asked Professor Eugene Fama (who later won a Nobel Prize for his work on asset prices) whether the market would become less efficient as more active investors dropped out. His answer was that it depends on who drops out. If less-skilled investors and managers quit active management, it would leave a smaller pool of more-skilled investors who should price securities more efficiently. But because markets work best when there is a lot of competition, there could be a tipping point at which indexing becomes too large—though we’re probably a long way from it.

Index equity funds currently account for 48% of assets invested in U.S.-listed mutual funds and exchange-traded funds, but that figure overstates passive funds’ impact on the market. Price discovery happens when shares change hands. Broad, market-cap-weighted funds tend to have much lower turnover than their actively managed counterparts, so their share of trading volume is considerably lower than their share of assets. In a recent study, Vanguard estimated that stock index funds account for less than 5% of trading volume on U.S. exchanges.1

3 | Passive investing exacerbates, and suffers from, market dislocations by allocating more money to areas of the market as they become more overvalued.

Given their low share of total trade volume, it’s unlikely that broad, market-cap-weighted index funds significantly magnify mispricing in the market. However, it is true that they tend to increase their exposure to areas of the market as their prices increase relative to others. Stocks in these market segments may have lower expected returns than cheaper stocks. Market capitalization is just price times number of shares outstanding. If a stock’s price increases faster than average, it tends to become a bigger part of the index, which conflicts with traditional value investing. I think this is a fair criticism of passive investing.

There are clear examples where market-cap weighting led to some large weightings in areas of the market that had been hot but subsequently underper­formed. In December 1999, technology stocks represented 27% of the S&P 500, up from 12% three years earlier, just in time for the tech crash. Similarly, after a strong run in the 1980s, Japanese stocks grew to just over 60% of the MSCI EAFE Index by 1989. They then lagged over the next two decades.

That said, such examples where the market widely misses the mark are rare. Most stocks that trade at high valuations do so for good reason, so it’s often difficult to spot mispricing in real time. However, investors who are concerned about the market’s tendency to load up on expensive securities might consider a fundamentally weighted index fund.

In part 2 of this article, we will discuss the other arguments against index funds.

1 Vanguard. 2019. “A drop in the bucket: Indexing’s share of U.S. trading activity.”

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Alex Bryan

Alex Bryan  Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.

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