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How Index Funds Make Markets Less Efficient

Many see Wall St. as a game, pure and simple. And the only rule is: money always wins.

"It's not a question of enough, pal. It's a zero sum game. Somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another."

Gordon Gekko's famous line is a near perfect synopsis of dynamic market theory. But it's not the whole truth. The reason why investing is not a zero sum game is because the number of participants and the amount of money being exchanged is constantly changing.

I'd like to take a look at how the success of the index fund and passive investment philosophies are impacting the long-term efficiency of the market. I don't think that even Eugene Fama really thought that markets were perfectly efficient in the short run, but I've always thought that they are more or less efficient over the long run. However, wide scale adoption of passive investing strategies like ETFs and index funds are changing the market in unexpected ways.

The increased popularity of ETFs and index funds over the last two decades is indisputable. The rise of passive investments as a percentage of total market assets has grown steadily to more than 15% of today's market. The influence of indexing is most pervasive in the large-cap space. As market research tools and brokerage access become more widely available, large cap active fund managers are having an increasingly difficult time defining their value added services as the value of information arbitrage collapses.

Conversely, the appeal of index funds is rather straightforward. They offer low cost and diversified exposure to a desired market or sector. Indexing's appeal is enhanced greatly by the difficulty of sourcing skilled active managers.

The popularity of indexing comes at a cost. The April issue of the Financial Analysts Journal has some interesting research on the growth of index investing and argues that increased indexing leads to increased correlations between individual stocks. As indexing increases, money put into or taken out of the market results in the purchase or sale of constituent stocks en masse. This is just common sense. Correlations amongst individual stocks is increasing as stocks are increasingly traded in tandem. As a consequence, underlying market risk is increasing as well.

In addition, index funds are decreasing the effectiveness of corporate governance boards. One of the main ways that investors show displeasure is with their feet. Selling stock. But this tool is becoming less effective as passive investors represent an ever increasing percentage of stock holders. With voting rights in the hands of passive investors, there is less influence generally for activist investors.

Conversely, where investors are losing influence on governance, traders are gaining influence over price volatility. If a large enough fraction of investors allocate a constant share of their wealth to a given index, then even a relatively small measure of noise traders can have a large impact on stock prices. Why? Because passive investors effectively decrease the float of a given security. The elasticity of demand for any given stock changes with passive investment, and can result in outsized volatility.

There is real world evidence of this in the volatility of Sears Holdings (NASDAQ:SHLD), which is majority owned by just two investors, and short interest often comprises more than half of the shares available to retail investors.

The upshot of all this is that passive indexing probably increases the value of active management. Higher volatility coupled with higher correlations creates more opportunities for active managers to make a positive impact on portfolio performance simply by deviating from the index. Picking a skilled manager will remain as difficult as ever.

Why Investors Shouldn't Care

The greatest myth in the active versus passive debate is that the success of indexing is somehow related to whether markets are efficient or not. But it just doesn't matter either way.

The efficient market hypothesis (EMH) was developed by Eugene Fama in the 1960s. Basically, the theory says that all known information about a stock is already reflected in its price. Apologists for EMH are often vocal proponents of passive indexing for pretty obvious reasons. But somehow over the years the idea of index funds and EMH have become conflated, as if belief in one requires belief in the other.

The logic of indexing rests solely on minimizing expenses.

We can prove this by comparing a hypothetical efficient and inefficient market. An inefficient market will have winners and losers, obviously. Likewise, an efficient market will still have winners and losers. The only difference is that the spread of their relative performance will be much smaller. While the vast majority of investors might be within 1 percent of the market index in an efficient market, the difference could be immense in an inefficient market.

But regardless of the margin of victory or loss, there is no denying the fundamental mathematics of investing that Nobel Laureate William Sharpe explained so well: by definition investors as a group will earn the market's return before costs, and will lag the market's return after costs. This is true for both the stock market over all, and the individual sectors that it's composed of. The market is the sum of its participants.

So while there will be bigger winners and bigger losers in an inefficient market, an investor in either market who minimizes his or her expenses will, by definition, earn returns that outpace the returns earned by the average of market participants. The stock market is still a game. And the rules are based on some pretty straight forward math.

Source: Index Funds Make Markets Less Efficient