How Indexing Distorts Investment Reality

Is indexing the perfect investment solution for the majority of investors—or is it the most dangerous threat to free markets since Communism? Is the investment management business an intelligent way for an investor to access expertise—or is it a collection of greedy and incompetent thieves? Like most things in life, reality is somewhere between the extreme portrayals that tend to inhabit the media, and taking time to peel away the more nuanced layers is a valuable and productive exercise.

Modern stock market history has no precedent for the current influence indexing has on investor behavior and attitudes. Indexing is reshaping the public discussion about how to invest. Its simplicity, academic pedigree and remarkable track record have elevated it well beyond a mere investment strategy or even philosophy. I don’t think it’s an exaggeration to conclude that for a growing percentage of participants indexing is now the lens through which they experience and interpret investment reality.

Conventional wisdom informs us that the goal of active investing is to outperform the market. After all, if you can’t generate above-average returns, what’s the point of using professional management? This is a logical, sensible, even obvious conclusion. There is however, one small problem: outperforming the market is not a goal—outperforming the market is a result. And that seemingly infinitesimal, inconsequential, semantic, angels-dancing-on-the-head-of-a-pin difference is what has led investors, investment managers and most of the investment world down a proverbial rabbit hole.

The other side of that rabbit hole is an alternative reality where in order to keep their jobs, investment managers put aside what they know to be legitimate and successful investment strategies in order to chase the chimera of regularly outperforming their benchmark. This is not a little thing. The stakes are massive: trillions of dollars of investors’ capital, and billions of dollars of fees to those managers who can successfully and consistently beat their benchmarks.

Unfortunately, the most sensible and successful long-term investment strategies can be volatile and/or produce long stretches of poor returns—a legitimate headwind in a world where under-performance is treated with growing impatience and the presumptive threat of investors departing with their assets.

Those threats have actualized: In growing numbers, investors have been departing active managers. According to Morningstar, through Nov. 30 all but $1 billion of the $41 billion investors added to U.S. equities in 2013 went to Vanguard. In the competition for investors’ hearts, minds and dollars, the indexers are winning, and their lead is increasing.

The longer something works, the more likely that we will conclude that the elements behind its success are persistent and that the benefits can be assumed to be reliable. As a result we don’t think twice about the following common refrain: “With the exception of a handful of investment geniuses (Warren Buffett, Seth Klarman, Carl Icahn, etc.), everyone else should own index funds.”

An investor’s primary choice is most commonly portrayed as active investing versus passive investing. But that is not correct. The actual choice offered investors is active investing versus index investing. Indexing as an investment strategy is not the same as the index itself, and that is a critical distinction. An index is a mathematical calculation of investors’ aggregate behavior. Indexed investing, like every other investment strategy, impacts and shapes the supply and demand for securities in the market. The more money that is indexed, the more that indexing behavior impacts the market that the indexers are attempting to mimic.