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June 01, 2016 at 08:00 AM
The active/passive debate is over. The winner is indexing.
Legitimate claims about the benefits of this brilliant insight are true: it is cheaper than active alternatives; it regularly outperforms actively managed portfolios; and uniquely, it has exponentially greater capacity to maintain its edge, with more money from more investors than any active strategy ever conceived.
Investors are now dumping active funds and buying index funds irrelevant to market direction. According to Morningstar, investment in passive U.S. equity funds now exceeds 40% of total U.S. equity fund assets; up from just 18.8% a decade ago. The trend is accelerating, and for good reason: indexing’s advantages are self-evident.
All that remains unresolved is one final issue. To explain it, I’m going to lean on Nobel Laureate William Sharpe, whose academic work on the Capital Asset Pricing Model was built on the idea of the efficient market. There are perhaps a handful of individuals who understand the relationship between the market mechanism and indexing as well as Sharpe. Here’s how he concluded an address to the Monterey Institute of International Studies in 2002, about the use and benefits of index funds:
“Should everyone index everything? The answer is resoundingly no. In fact, if everyone indexed, capital markets would cease to provide the relatively efficient security prices that make indexing an attractive strategy for some investors. All the research undertaken by active managers keeps prices closer to values, enabling indexed investors to catch a free ride without paying the costs. Thus there is a fragile equilibrium in which some investors choose to index some or all of their money, while the rest continue to search for mispriced securities.”
The recurring meme in the indexing world holds that there will always be enough active investors, who, despite overwhelming evidence to the contrary, will persist in their self-defeating behavior — maintaining the efficient market and allowing indexers to continue their advantage indefinitely. This belief is widespread and often used to explain why indexing will never suffer from overreach.
Until the advent of indexed investing, investment strategies attempted to exploit something within the market: a trend, an inefficiency, a mispricing, irrational behavior or potential arbitrage. The unique and unprecedented feature of indexing was its ability to exploit the market itself.
Investor Overreach
All investment opportunities (including indexing) have a built-in limitation: if too much money flows in, the opportunity diminishes and then disappears. There has never been an instance of a successful investment strategy that didn’t attract too much money. Overreach is an integral part of the landscape and history of market and investor behavior. It shouldn’t surprise anyone that, with an opportunity set as large as the market itself, it has taken 40 years for indexing to reach a place where its potential threat to the efficiency of the market is no longer theoretical. Yet indexing’s most active proponents continue to argue that indexing will not become capacity constrained.
Cullen Roche of Pragmatic Capitalism (pragcap.com) is one of the more thoughtful proponents of indexing. He put up an interesting post a few months ago titled “Is Indexing Just Another Wall Street Fad?” He asked the same question as Sharpe: what happens if indexing grows so popular that it affects the efficiency of the market?
In contrast to Sharpe, Roche suggests that were indexing to become too popular, the result would be opportunities or inefficiencies that active investors would be able to exploit. This claim only works in a world where all market inefficiencies are exploitable — and that world doesn’t exist.
