A. Richard Allen/© theispot.com

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.

Investors have long known that just because there is an observable mispricing, inefficiency or valuation disparity in the markets, it doesn’t mean that there’s an equal opportunity to do anything about it. Sometimes there is, and sometimes there isn’t, but it’s hardly a given. And those investors who make their living exploiting disparities know well the difference between an exploitable opportunity and one where you’re just trying to pick up nickels in front of a steamroller.

Roche continues: “If everyone indexed, it would mean that much more market making to be done by the authorized participants.” For the record, “authorized participants” are large institutions whose sole activity is to keep an ETF efficient. This is a narrow, highly proscribed activity that is activated only when supply/demand dynamics get stretched and the ETF price starts to meaningfully diverge from the net asset value of its underlying components. The authorized participants then engage in an arbitrage that closes that gap — and make a small profit in the process. That is it.

Market making is an important and valuable service for customers of the market (i.e. investors). That market makers buy and sell stock to perform this service is no more a form of investing than credit cards (which make it so easy to buy stuff) represent the underlying source of consumer demand.

No one knows what will happen if too many investors jump on the indexing bandwagon, because it has never happened. The real question is: what should investors do now? On one hand, active investing appears to be (as Charles Ellis has brilliantly noted) a “Loser’s Game,” where it is next to impossible to identify, ahead of time, those managers who can even be above-average. On the other hand, the one strategy that has been bulletproof for the last 40 years might finally be in danger of becoming so popular that it will (in the best of outcomes) slowly kill the goose that laid the golden eggs.

One might conclude, “Well, investors should just index until it loses its advantage and then move onto some other strategy.” This is the “I’ll just sit here on the stern of the Titanic and slip into the water right before it goes under” fantasy. Just like large ships sinking can suck everything down with them, the more successful an investment strategy, the more likely its decline becomes a messy and highly disruptive event.

Since indexing’s advantage comes from its ability to exploit the market itself, it’s a logical conclusion that the health of the market itself is at risk if too many investors crash the indexing party. Indexing’s supporters are correct when they claim that more than a few active investors will persist far longer than they should. But that also means that indexing’s diehards — facts or events notwithstanding — will do the same thing if the tables are turned. Human behavior is consistent in that regard — it doesn’t matter what side you’re on.

Real Choices

The point everyone in the active/passive debate appears to be missing, is that the issue at hand is not whether active is better than passive. That has been settled. The real issue at hand is nothing more than the basic calculus of every investment choice we have to confront. Is what I’m gaining from the decision I’m about to make more valuable and important to me than what I’m losing? If I do this, what’s the most likely worst-case outcome — and could I live with it if it happens?

Like moths we are instinctively drawn to the light of what’s working. But light can blind as well as inform. The demise of indexing, if and when it actualizes, will not be the result of some internal weakness or flaw in its infrastructure; it will be because we overused it, abused it and expected far too much from it.

Whether our choices appear self-evident or unclear, we still have to make them. The choice facing investors today is not active or passive, but rather thoughtful or thoughtless. That is the only self-evident choice I know of with no downside.