Building a portfolio to mimic a popular index may be the most creative, insightful and successful investment idea of the last 50 years. Born in academia, tested and retested by millions of investors, it is simple, cheap, effective and immensely profitable for those fortunate investors who have climbed aboard—and stayed aboard.
But if John Rekenthaler is correct, indexing’s growing popularity may be accelerating far faster than anyone expected: In an early August column for Morningstar he reported that in the 12 months ended June 2014, nearly 70% of mutual fund and ETF purchases went into index funds.
The sheer immensity of the number just takes my breath away. In my lifetime, outside of a bubble or a panic there is no precedent for so many investors climbing aboard the same strategy at the same time.
This revelation alone could have been enough for some interesting commentary on my part. But it wasn’t until later in Mr. Rekenthaler’s commentary that he wrote: “As defenders of active management point out, investing can’t become 100% passive because then nobody exists to set prices.” Suddenly the stars aligned and I saw something I hadn’t really noticed before. And that became the catalyst for this column.
The statement is, of course, totally correct. However, it is one portion of a very typical and popular narrative about indexing—one that is at best logically inconsistent, and at worst not a description of reality. The narrative goes like this:
Indexing is the same as passive investing.
Because indexing is passive, it is not part of the price setting mechanism of the market—that is done by active investors.
Indexing can never become too popular because at some point it will cause the market to become inefficient. At that point active investors will exploit the inefficiencies, luring away enough investors from indexing to keep the market balanced.
I have seen this in various forms dozens of times. But it wasn’t until I read Mr. Rekenthaler’s piece that I realized this flawed narrative, in concert with the sad state of affairs and perverse incentives in the investment management industry, is leading a majority of investors to conclude that indexing is actually their only sane and sensible choice.
For the record I have nothing against indexing. If anything I’m an admirer of the brilliant insight behind the idea. As an advisor I get paid the same whether I use an index fund or an active fund. But it is a law of investing that when something very successful starts to become too popular, past a certain point risks will form where none existed before. This (and only this) is the nature of my growing concern about indexing.
With that in mind, let’s take a closer look at the indexing narrative:
“Indexing is the same as passive investing”: We all know what passive investing looks like. Your 80-year-old uncle Bernie started investing when he was 18. Anytime he had some extra cash, he bought some shares of mostly blue chip companies, took the certificates and put them in his safe deposit box, where they remained untouched for decades. Uncle Bernie is now living on the dividends and his shares will be passed on to his heirs when he dies. That is passive investing.
In the early years of the advent of indexed mutual funds, one could legitimately claim that indexing, while perhaps not totally passive, was benign enough to be somewhere in the “passive adjacent” neighborhood. But the immense popularity of ETFs lured indexing away from that neighborhood a while ago.
“Indexing is not part of the price setting mechanism of the market”: Market prices are set by one thing and one thing only: supply and demand. The aggregate behavior of all market participants creates supply and demand—and therefore sets prices.
Healthy markets—efficient markets—are driven by participants who act independently from each other, and whose diversity of opinion, strategy, knowledge and wealth come together to form the foundation of a truly remarkable and beneficial enterprise. Of course, markets are not perfect and periodically market participants will start acting in concert with one another—reducing market efficiency and health. The most famous examples of this are speculative bubbles and their aftermath. But as we are now witnessing, speculation (or panic) is not the only reason for investors to act as one.
It doesn’t matter what is driving the supply and demand for securities: It could be fundamental research, bottom-up valuation, top-down macroeconomics, technical analysis, momentum, astrology—or more lately and more frequently, funds that make their purchase and sale decisions in order to match an index. The most important factor in supply and demand (price-setting) is size. The bigger you are, the more money you have, the more that your trading behavior will influence supply and demand.
The big stick in the market is increasingly being swung by index-shaped securities. The latest estimates suggest that about 30% of all U.S. equities are indexed. Even if index funds were not truly passive, if their only use was by long-term investors, one would expect that their impact on daily trading would be minimal, in the low single digits for sure.
That is not what is happening. According to data from the NYSE Euronext, exchange-traded funds (ETFs) accounted for 27% of all trading volume in all U.S. markets during 2013. Yet despite overwhelming evidence to the contrary, the fantasy persists that indexing doesn’t affect supply and demand.
“Indexing can never become too popular because there will always be enough active investors to keep the market efficient”: This is indexing’s Get Out of Jail Free card—a clever piece of self-deception built on just enough logic to sound reasonable.
Financial markets are self-correcting; that is one of their enduring strengths. But anyone with even a cursory understanding of market history knows that markets can remain inefficient for challengingly long periods and the ultimate self-correction, when it happens, is rarely if ever a benign affair.
When inefficiencies of pricing are the result of too many investors with deeply entrenched convictions controlling too much money, those inefficiencies are almost impossible to exploit. Smart investors are not going to waste their time trying to pick up nickels in front of a multi trillion dollar indexing steamroller. They are keenly aware of the observation, often attributed to Lord Keynes that, “Markets can remain irrational longer than you can remain solvent.”
I’m sure that Lewis Ranieri had no idea that the plain vanilla mortgage securities he created in the late 1970s would turn into the convoluted, leveraged and opaque instruments that nearly brought down the financial system in 2008. And I’m equally certain that indexing’s godfather, John Bogle, never anticipated the seemingly unlimited uses institutional investors appear to be finding for indexed ETFs and the not yet actualized risks those growing uses imply.
If the market activity coming from indexing-shaped sources continues to increase, the drivers of supply and demand will continue to narrow and the market will continue to grow less efficient. How and when the ultimate risks of that combination actualize is impossible to predict. But when enough investors start to suspend rational thinking in order to justify an investment strategy, it’s certainly worth a few moments of our time to consider the implications.
Investing is not challenging because it is hard to see into the future. Investing is challenging because it is often hard to accept what is so easy to see in the present.