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Two economists are walking down the street. One sees a dollar lying on the sidewalk, and says so.
"Obviously not," says the other. "If there were, someone would have picked it up!" "That's so very true", says the first, and they both go about their business.

My father-in-law enjoys putting money in companies that are exciting and tell inspiring stories. Companies like Tesla (NASDAQ:TSLA) and Sirius (NASDAQ:SIRI) make him optimistic about the future of business, and he wants to be a part of the vision. What he does not enjoy is the tedious grind of studying financial statements, digging through a company's prospects and pricing it. He is not alone. Amongst my friends and family, I'm the only person I know who invests his money with the idea of buying a company at a value, regardless of its business, rather than "investing" in an idea or dream. For all the people I know, and the millions like them, index investing is almost certainly the smartest way to participate in the stock market.

But there are those who are willing to do the work and find the opportunities, or scraps from the table, that Mr. Market tosses to us from time to time. On this very website, they exist in all kinds forms, calling themselves DG investors, value investors, contrarians and growth investors. They face a litany of studies and economic theories proposed by world-renowned economists that tell them their life's work is in vain. Efficient Market Hypothesis (EMH) proponents hold the high ground because A) cynicism is cool and B) you can't disprove a theory that says any contradicting "evidence" is due to luck. Investors with over 20 years of market-beating averages on this site are routinely assured they are simply lucky.

The irony of course is that without market participants seeking the mythological alpha, EMH falls apart. Like economists passing up free money, EMH proponents recognize collective market participation irons out mispricing, but seem to forget it's real individuals who do the ironing.

How quickly market prices correct depends on many things, and are not in the scope of this article. It should suffice to say that opportunities to find miss-pricings are rare, and sometimes they disappear too quickly for individuals to exploit. Conventional wisdom states that with greater access to financial information, news, and ease of trading, active investing is becoming futile. However, I believe that the future for active investors is getting brighter even as public opinion seems to be turning against them.

Everybody who's Anybody is doing it…

The Wall Street Journal recently ran a front page article that cleverly illustrates the market sentiment shift against active funds.

Some of the highlights are

  1. Last year, stock investors pulled $127 billion out of actively managed stock mutual funds, while pumping a net $70 billion into index funds and ETFs.
  2. This year investors have pulled $3.1 billion more out of actively managed stock funds. They have poured $45 billion more into the lower-cost alternatives.
  3. Legg Mason mutual fund soared 40% and beat its benchmark by a wider gap than any other U.S. stock fund with $50 million or more in assets, but investors have pulled $196 million out of it.

These three bullets paint a picture: investors are fleeing actively managed funds, and pouring money into index ETFs and passive mutual funds, which already are a powerful force in the market. If you are a fund manager overseeing a small pool of actively managed assets, this has to be a worrying trend. But if you are an individual investor, not subject to the whims of the masses, this should be an exciting development for you.

According to Morningstar (via Vanguard), U.S. domiciled index mutual funds and exchange traded funds accounted for 34% of equity funds by the end of 2012. Throw in international index funds, and passive investments are a strong force on corporate valuation, and it's a force driven by people who don't even care about any individual company's value. As I've pointed out above, this force is increasing every year.

When I see the crowd stampeding in one direction, I like to get out of the way. Sometimes that means fleeing the scene completely, and sometimes it means occupying the space they fled. In this case, I believe that being contrary will yield results.

To understand why I think active investing may become progressively more successful, one must understand how indexing can distort individual prices. Fortunately, the concept is relatively straight forward. Index funds purchase assets that allow them to try to match the performance of their model index. For instance, the SPDR S&P 500 ETF (NYSEARCA:SPY) mimics the S&P index (no surprise).

State Street Global Advisors can charge small fees because it doesn't decide on what stocks to buy, how much of each stock to buy, or when to sell. It simply acts to stay in synch with the S&P 500.

Furthermore, the S&P 500 committee, when deciding on its asset membership, is not looking at a company's valuation the way a fundamental analyst would. The committee cares about current market capitalization, liquidity, overall financial health, and business sector, and a few other categories. In other words, the committee concerns itself with stock popularity and overall economic representation rather than valuation.

There is nothing wrong with this from the standpoint of developing a way to measure overall stock market sentiment and growth. Utilizing the index as a financial product, however, changes market dynamics. And when that tool becomes the dominant product in the market, investors must ask, "Who's minding the shop?" Suddenly large portions of market participants are no longer "voting" for which companies deserve their investment dollars. They are simply dumping money into a product on the faith that the overall market will net positive returns. Those who are trading in and out of the index, are doing so based on their evaluation of broad market prospects as well.

The result is underperforming stocks get bought up in greater numbers because they are index members. Stellar companies do not get bid up high enough for the same reason. The streets have become crowded with pedestrians who can't or won't see the money on the street much like the two economists in the introduction.

Theory is great, but…

Index funds distort stock prices. This fact is not just theory, it is observable. Two of the easiest ways to observe the impact of indexing, is by looking at dual listed companies, and by looking at impacts on securities after listing notification is released.

Dual listed companies are formed when two corporations merge, but choose to retain separate legal identities and exchange listings to maintain tax advantages for their stockholders. Both groups of shareholders lay claim to a consistent portion of the joint cash flows, based on valuation at the merger.

Since dual listed companies draw from the same cash flow, they give us an opportunity to study efficient market principles. When Royal Dutch Shell (RSD.A) was still a dual listed company, for instance, its cash flow was broken into a 60:40 ratio for Royal Dutch and Shell. In a perfectly efficient market, Royal Dutch stock prices should have been 1.5 X that of Shell's, when adjusted for currency. But -30% to 20% deviations from this ratio were commonplace, and these mis-pricings could last for years. Royal Dutch Shell is not the only dual listed company to show these tendencies. Studies on the subject matter can be found here, and here.

In most, if not all of these dual listed companies, the two companies exist on different exchanges, and are included in different indexes (or one is not included in an index). The consequences are that their share prices reflect local market sentiment, and not the underlying cash flows.

Another opportunity to see index investment effect on an individual company's share price is to look at the effect on share price when a large index announces the stock is one of its additions or deletions. This effect is documented in several studies, one of which can be viewed here. According to Mr. Petajisto (he's a Seeking Alpha contributor by the way), an average of 10% of a stock's shares will be bought up by index funds to match the underlying index addition. You can imagine that this may have a large impact on share prices, and it does. For the five days after announcement and before addition to the S&P 500, stocks tend to rise in prices by 1% (when adjusted for overall market returns). Deletions tend to show a drop per day equal in magnitude, except that they tend to drop prior to announcement quite a bit as well. Since deletions are more likely to affect stocks that are performing poorly, some of this affect may be explained away by selection bias. The same study finds similar results with Russell 2000 stocks as well.

Of equal interest is the fact that this premium has not been consistent through time. In the 1980s the premium over the month before a stock was added to the index averaged 3.5%. In the 1990s, as index investing came into its own, the premium grew to an average of 9.2%. But by the early 2000s, the index premium dropped again, to an average of 4.5%. Mr. Petajisto speculates that this decrease was due to the substantial rise in popularity of hedge funds. More hedge funds could both water down the influence of index investing, and arbitrage away some of the market distorting effects.

And now, things are different?

If you believe that the trend towards indexing will get stronger over the next decade, and you understand that indexing leads to individual stock mis-pricing, it's easy to connect the dots. The market, and therefore individual stock prices are determined primarily by overall economic sentiment, perhaps more than any other time in history. The market is not the perfectly rational exchange that economists imagine. It will become more and more common place for individual stock prices to deviate from their theoretical value, and they will stray from that value for longer periods of time. Investors who pick diligently hunt for bargains, and who have some aptitude for doing so will outperform those who passively invest in indexes. But if you still buy this argument, there are still two questions you should be asking.

  1. What about the hedge funds? Won't opportunities simply be exploited by the growing hedge fund industry?

Undoubtedly, some opportunities will be exploited by hedge funds. Hedge funds continue to grow in popularity, but they do not all focus on purchasing stocks. In 2012, the hedge fund industry managed over $2.13 trillion total assets. That total includes worldwide equity, real estate, commodities, currency, and assorted other assets. By contrast, index funds hold roughly 11% of U.S. assets, or $1.14 trillion dollars. But this is comparing apples to oranges. If we were to extrapolate hedge fund percentages of the world equity market to be the same as their percentage of U.S. equities, hedge funds would hold roughly $500 million in U.S. equities. Only some percentage of that number would be equity "value" holdings. A massive movement by individual investors and pensions (and some hedge funds) into passive investments will most likely drown out any effect actively managed hedge and mutual funds will have on asset prices.

  1. If "everyone" is investing in indexes, how will assets correct? Won't "index driven prices" be the new "normal"?

Perhaps, for a time. But investors aren't the only participants in the marketplace. Corporations are free to buy and sell shares of their own company. So if a company gets significantly undervalued, it is in the shareholders' interest for the company to buy up shares. If shares get significantly overvalued, the company has a cheap source of financing projects. This strategy is not always easy to pull off in the current market. Buying and selling company shares is not as easy or quick for the corporation as it is for individuals. The miss-pricing must be extreme, and it must last for a while before CFOs are likely to be willing to buy or sell shares simply to capitalize on share price.

But in a market where valuations no longer correlate with company performance, it would be in management's interest to capitalize on growing miss-pricings. Over time, individual actions combined with share repurchases/share sales should correct the price of shares to proper valuations.

Bottom Line

For years, newspaper headlines, magazine articles, and popular investment gurus have touted index funds and ETFs. Blogs run stories like "Index Funds Win Again-This time by a Landslide," which spread the message to the common man and money manager alike that indexing is the logical way to go. Past results seem to bear this out. But indexing's growing popularity is the seed of its own downfall. The premise of investing in indexes relies heavily on the Efficient Market Hypothesis. But mass participation in index investing undermines an efficient market. Gaps will open, holes in efficiency will appear, and active investors will be there to take advantage of them.

In the long run, average returns for active mutual funds (and individual investors) should rise above index fund returns, and money will start to shift back into stock picking. When indexing is mocked in Wall Street Journal Editorials and Money Magazine, we will know the cycle is complete, and the contrarian will start to shop for passive funds.

Below are two more links somewhat tangential to this article's topic. Please review them if you are interested in learning more about how index funds distort equity prices. Thank you for taking the time to read.

Hidden Costs

White papers [pdf]

Source: Passive Investors Shouldn't Rest On Laurels ... Active Investing May Be The Future