Indexing is the practice of buying all the components of a market index, such as the Standard & Poor’s 500 Index, in proportion to the weightings of the index and then passively holding them. An index fund manager does not look to buy or sell even at attractive prices. Even more unusual, index fund managers may never have read the financial statements of the companies in which they invest and may not even know what businesses these companies are in.
Indexing has become increasingly popular among pension funds, endowments, and other long-term investment pools for several reasons. Indexing guarantees matching the performance of the securities in the index. Most people can’t and don’t beat the market, especially in markets that are more-efficient. And since all investors as a group must match the market because they collectively own the entire market, matching it may seem attractive. Indexing offers the additional benefits of very low transaction costs (as there is almost no trading) and low management fees (as the task requires virtually no thought or action). The only aspect of active management with potential to offset these negatives is alpha, or personal skill. However, relatively few people have much of it. For this reason, large numbers of active managers fail to beat the market and justify their fees. Another reason for the trend toward indexing is that many institutional investors and pension funds believe in the efficient-market hypothesis. This theory holds that all information about securities is disseminated and becomes fully reflected in security prices instantaneously. It is therefore futile to try to outperform the market. A corollary of this hypothesis is that there is no value to incremental investment research. The efficient market theory can be expressed, according to Louis Lowenstein, “as a much-too-simplified thesis that one stock is as good as another and that, therefore, one might as well buy thousands of stocks as any one of them.”
By contrast, value investing is predicated on the believe that the financial markets are not efficient. Value investors believe that stock prices depart from underlying value and that investors can achieve above-market returns by buying undervalued securities. To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffet has observed that “in any sort of a contest—financial, mental or physical—it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.”
Indexing is a dangerously flawed strategy for several reasons. First, it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis. Indeed, at the extreme, if everyone practiced indexing, stock prices would never change relative to each other because no one would be left to move them.
Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover. Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers. There are implicit assumptions in indexing that securities markets are liquid, and that the actions of indexers do not influence the prices of the securities in which they transact. Yet even very large capitalization stocks have limited liquidity at a given time. Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yesterday. In effect, people are willing to pay more for that stock just because it has become part of an index.
A related problem exists when substantial funds are committed to or withdrawn from index funds specializing in small-capitalization stocks. Such stocks usually have only limited liquidity, and even a small amount of buying or selling activity can greatly influence the market price. When small-capitalization-stock indexers receive more funds, their buying will push prices higher; when they experience redemptions, their selling will force prices lower. By unavoidably buying high and selling low, small-stock indexers are almost certain to underperform their indexes.
More significantly, a self-reinforcing feedback loop has been created where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing. When the trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits.
In passive investing, no one at the fund is studying companies, assessing their potential, or thinking about what stock price is justified. And no one’s making active decisions as to whether particular stocks should be included in a portfolio and, if so, how they should be weighted. They’re just emulating the index.
Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings? Certainly not. But passive investing dispenses with this concern by counting on active investors to perform those functions. The key lies in remembering why it is that the Efficient Market Hypothesis says active management can’t work, and thus why it expects everyone (good or bad luck aside) to just end up with a return that’s fair for the risk borne … no more and no less.
And where do the weightings of the stocks in indices come from? From the prices assigned to stocks by active investors. In short, in the world view that gave rise to index and passive investing, active investors do the heavy lifting of security analysis and pricing, and passive investors freeload by holding portfolios determined entirely by the active investors’ decisions.
The irony is that it’s active investors—so derided by the passive investing crowd—who set the prices that index investors pay for stocks and bonds, and thus who establish the market capitalizations that determine the index weightings of securities that index funds emulate. If active investors are so devoid of insight, does it really make sense for passive investors to follow their dictates? And what happens if active investors quit doing that job?
If widespread active investing makes it impossible for active investing to succeed (by making markets too efficient and security prices too fair, per the Efficient Market Hypothesis), will the increasing prevalence of passive investing make active investing once again potentially profitable? When the majority of equity investment comes to be managed passively, prices will be freer to diverge from “fair,” and bargains (and overpricings) should become more commonplace. This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective.
Passive/index investing got its start because of a view that the stock market would grind on as it always had, with active investors setting “proper” prices for securities. That would enable passive investors to participate in the markets—assembling portfolios that mimic the indices and “free-riding” on the work and price discovery performed by active investors—without picking up their share of the analytical tab.
But that misses the reality behind George Soros’s Theory of Reflexivity: that the actions of market participants change the market. Nothing in a market always continues, independent and unchanged. A market is nothing more than the people in it and the decisions they make, and the behavior of those people shapes the market. When people invest more in certain stocks than others, the prices of those stocks rise in relative terms. And when everyone decides to refrain from performing the functions of analysis, price discovery and capital allocation, the appropriateness of market prices can go out the window (as a result of passive investing, just as it does in a mindless boom or bust). The bottom line is that the wisdom of investing passively depends, ironically, on some people investing actively. When active investing is dismissed totally and all active efforts cease, passive investing will become imprudent and opportunities for superior returns from active investing will reemerge.