From the October 2017 issue of Research Magazine • Subscribe!

Isn’t Indexing Perfect?

When it comes to investment strategy, some truths (about risk) are worth remembering

There was no plan.

Historians in the future will find no evidence of a conscious or coordinated effort. The path that led to an environment so perfectly suited to one unique kind of investment strategy changed the very nature of how people thought about the enterprise itself. Yet that path, which we still appear to be on, was completely unintentional.

Active professionals had been applying increasing amounts of intelligence, money, experience, information and time to maintain their investment edge. Whatever was driving their actions, it didn't have the goal of creating an ecosystem so antithetical to their interests that it would endanger their own existence. And yet, that is exactly what happened.

In 1993, I came across the then-recently published book, “Investment Policy” by Charles D. Ellis. Among other insights, Ellis explained why professional investors had (and would continue to have) difficulty producing above market returns. He laid out his thinking so clearly and compellingly that I refer to it even now, and he revisited the same theme earlier this year in a piece for the Financial Times, “The End of Active Investing?”

Ellis's argument is built on the observation that as professional investors began to dominate the market, it became more difficult to produce market-beating returns. Today, there are 135,000 chartered financial analysts (or CFAs), another 200,000 studying for the exam and an estimated 320,000 Bloomberg terminals providing over 1 million professionals with sophisticated access to anything and everything related to investing — in short, all the makings for an amazingly efficient market.

Ellis identified four distinct phases over the last 50 years that led to today's market environment: In the first phase, institutional market share was less than 20%, and active managers easily outperformed the averages. In the second phase, institutional market share was less than 50%, and active managers generally equaled market returns (before expenses).

In the third phase, institutional market share began to dominate the market, and active managers regularly underperformed. In the fourth phase, as institutional market share rose above 90%, so few active managers matched market returns that investors, large and small, started to seriously question the value of any active management.

It gets worse (for active investors, that is). John Bogle, who got the indexing ball rolling in 1975, says institutional market dominance is not relevant to indexing's advantage over active alternatives and that markets were efficient even when institutions were small participants.

Writing in the Financial Analysts Journal last year, Bogle compared the returns of the S&P 500 index to average equity mutual fund returns in two 30-year periods: 1945-1975 and 1985-2015. Even though institutions were an inconsequential part of the market in the first period and dominated it in the second one, the index beat the funds in each timeframe by 1.6% per year.

The Market Wins

Whether you agree with Ellis or Bogle, the only logical conclusion you can make is that it is a fool's errand to think you can beat the market, and it is a fool's errand to think you can pick an active manager who can beat the market.

It doesn't matter whether individual investors are making the market efficient or institutions are making the market efficient. The market is going to be efficient enough to give indexing what it needs to maintain an advantage over almost anyone who tries to do it themselves.

Oh, a few people will succeed: Warren Buffett, Klarman and some others perhaps. There are meaningful studies that show that value and momentum have persistence, and over many years can produce above-average returns. But the odds of identifying the managers who can successfully deliver those returns are not great.

The typical criticisms of indexing have always felt slightly inadequate. Consider just a few: The top heaviness of indexes makes them dangerous during bubbles. We’ve had two massive market bubbles and crashes since 2000 and indexes have come out looking just fine.

One recent blogger suggested that the last trillion dollars coming into index funds was “hot money” — i.e., investors chasing performance — and this hot money would rush out at the first sign of trouble, leading to a market collapse. That may be so, but I doubt any meaningful amount of money coming out of index funds will be flowing back to active managers any time soon. That ship has sailed.

Most observers whose thinking aligns with Ellis and Bogle conclude that investors who have yet to jump on the indexing bandwagon should climb aboard soon. After all, how many more data points do they need to convince themselves of its overwhelming advantages?

Whether you’re an individual investor, an advisor or have responsibility for institutional assets, when you look out at the investment alternatives, your objective is to make good decisions — ones that, irrelevant to the outcome, will continue to look sensible and well-reasoned, and most important, serve your best interests.

About 10 years ago, I noticed that more and more investors and observers were thinking about their choices in a binary fashion: Should I be active or should I index? Over the last three to five years that thinking has narrowed to: Why shouldn't I index? It's a logical question.

With indexing, you have a strategy that is simple, cheap, tax-efficient, available to everyone and capable of handling almost any sum of money — one with historical returns that beat most of active alternatives. With active investing, you face a complex array of choices — different strategies, different managers, unpredictable tax consequences, costs many times that of index funds and a history of below-average returns.

Is it any wonder that the move to indexing is accelerating? Rarely have I seen an investment choice so self-evident and so obvious. I have tried to be clear and objective about this issue. There is no debate about the academic and intellectual foundation of indexing, its performance advantage, its simplicity, its cost-advantage and its ease of implementation. Every investor who decides to index is making a completely rational choice for him or herself.

Future of Indexing

If investing didn't exist on a continuum, this would be the logical end-point of the discussion. But investing does exist on a continuum. What was popular can fall into disfavor. What was ignored can become important. What works can stop working. Something that dominates the minds of investors can become irrelevant. Good markets can become bad markets. It goes on and on.

Unfortunately, predicting or even identifying these transitions is almost impossible. The one exception to this is human behavior. Unlike the performance warning plastered on every piece of investment literature, past behavior does guarantee future behavior.

Of course, individuals can and do learn lessons, and can avoid repeating both their own and others’ mistakes. Collectively, however, investors have memories like sieves, perpetuating the market version of “Groundhog Day:” repeating the mistakes of past investors, who repeated the mistakes of investors before them, ad infinitum, ad nauseum.

If we agree that indexing is the most perfectly suited investment strategy for today's market environment and that the more active investors strive to beat the market, the more advantage they hand to indexers — then the future success and/or demise of indexing is squarely in the hands of those who hope to benefit from it.

What then is the probability that indexers will engage in behavior like that of past investors? Will indexing be the exception, and become the first popular investment strategy in history to avoid attracting too much money? Or will its future be more familiar (as described by Jeremy Grantham) — “excellent fundamentals irrationally extrapolated”? If you’re playing the odds, this is not a question of if, just a question of when.

How can I be so sure that too many investors will climb aboard the indexing train? Well, I can't be 100% sure. No one can be. But there are just too many examples of participants whose livelihood came from a shared resource — grazing lands, fish habitats, waterways, etc. — who, in the process of acting in their economic self-interest, destroyed the source of the very benefits they were enjoying. Known as the “tragedy of the commons,” it best explains both the behavior and logical implications of too many investors with too much money chasing a huge but still not unlimited resource.

Whatever is in the minds of investors who are attracted to indexing today, it doesn't have the goal of creating an ecosystem so antithetical to their interests that it could endanger the very market environment that they hope to exploit. And yet that is exactly the collective direction they are taking.

Will indexers self-regulate and accept lower returns with expensive active alternatives? Or will investment behavior simply repeat itself, as one investor after another capitulates to indexing and its increasingly self-evident benefits?

Indexing taught us that successful investing can be simple. But investors need to remind themselves, regularly, that it is never easy. As Howard Marks brilliantly said, “The riskiest thing in the world is the widespread belief that there is no risk.”

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