Passive Funds Are Just Free-Riding Active Funds

by: Sami J. Karam

Summary

Of course, passive funds outperform active funds.

But past a certain market share, they will deliver low or negative returns.

And damage the functioning of the financial markets.

If you and your neighbor have the same income and expenses except that he rides the bus for free every day while you pay a fare, he will be richer than you. Until recently, this was obvious: the neighbor is a free rider while you pay your way.

But now, the obvious is presented by some as a eureka moment. Now, plenty of people are extolling the benefits of free-riding without naming it as such and encouraging a large exodus from active to passive (or indexed) funds (like the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) or the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY)). The only problem is that proponents of this form of free-riding neglect to also mention the following corollary sub-plot.

Now your neighbor makes you feel like a fool and convinces you to also ride for free. Soon, your whole town has caught on to the idea and fewer and fewer people are willing to pay for the bus. After a while, the number of people supporting bus service with their dollars becomes so small that buses go out of business or fall into a state of disrepair.

Some will protest that indexed funds are free riding. Then let us ask the following:

  1. Do we need asset prices to reflect reality and new information? Yes, in order for capital to be allocated efficiently to promising company A instead of failing company B.
  2. Do we need active human involvement (or algorithms written by humans) to translate new information into asset prices? Yes, how else would it happen?
  3. Would the markets break down, i.e. go out of business or fall into a state of disrepair if a large percentage of funds became passive funds? Yes, as information would no longer be reflected in prices and capital would be misallocated.
  4. Would then investors in passive funds be able to invest in the markets? No.
  5. Are investors in active funds paying for all this while investors in passive funds are not paying for it? Yes.

Then, indexed funds are free riding.

The same points are addressed in more detail below.

With the accelerating outflow from active funds and into passive, proponents of passive investing have become ruthlessly triumphalist, pushing for even more transfers into indexed funds. Yet the notion that active funds underperform indexed funds is nothing new. It has been known and widely publicized for decades. Again, paying for something is less good than not paying for it, so long as someone else pays for it. The last part bears repeating: so long as someone else pays for it.

Parenthetically, let us agree right away that fees charged by active funds are too high. Mutual funds benefit from enormous economies of scale that greatly enrich portfolio managers and principals. And hedge funds charge very high fees despite their spotty mid and long-term track records. While there is clearly room for reducing fees on active funds, however, we can expect that as a group, they will still underperform passive funds even after fees have been reduced.

Give me 100% market share, but not yet!

If we follow the rationale deployed by advocates of indexed funds to its logical end, all investors should liquidate out of their active funds and move to passive. This extreme scenario would be inconvenient to the passive industry, however, because it would create a host of other problems. Instead, like St. Augustine praying for the Lord to "give me chastity and continence, but not yet", the passive management industry should be hoping for 100% market share but not yet.

Consider the consequences of active management being completely crowded out and eliminated by passive funds.

The first consequence would be less efficiency in the markets, meaning that stock prices (or prices of other securities) would greatly deviate from their intrinsic worth. In a world without analysts and portfolio managers (remember, no active funds), there will be no transmission mechanism for reality to go into asset prices except when a company makes an announcement. In theory, a company could mislead shareholders for years before coming clean about its failing accounts. Even then, it is not clear that its market value would react accordingly because indexed funds would not be trading it so long as it remains in the index. Meanwhile, the small company that will be the next Microsoft (NASDAQ:MSFT) or Google (NASDAQ:GOOG) (NASDAQ:GOOGL) will have a languishing stock price because it is not included in any stock index.

From a capital allocation point of view, this scenario would be disastrous because it would funnel more capital to fading companies or to incompetent managers while also starving the brilliant new start-ups.

The second consequence would be lower liquidity. As the market share of indexed funds grows, more and more shares of companies are taken out of circulation. When an indexed fund receives inflows, it buys more of the shares of companies that are included in the index. These shares are essentially taken out of circulation and never traded again unless the fund starts to see outflows and needs to liquidate some of its holdings. The free float of companies then gets progressively smaller, which means that there is a lot less liquidity in the markets. In theory today, indexed funds can put the shares they own back into circulation by lending the stock they hold to hedge funds which want to short it. If this practice is taking place today, there is no more implicit acknowledgement by the passive industry that it is dependent on the active. But in a world of 100% passive funds, there will be no more hedge funds to lend stock to.

Of course, passive fund executives would say that 100% market share would never happen. This is not just realism but also the reassurance that they need. Remember the free rider on the bus. He would not mind if there are other free riders so long as there remain enough payers to keep the buses running. But he would very much rue the day when everyone becomes a free rider because the buses would then stop running.

Hidden cost of indexing

What is the equivalent of 'the buses stop running' when we are talking about the financial markets? It means that they would stop working as a mechanism to price securities as fairly and efficiently as possible. They would stop working as a mechanism to allocate capital efficiently to the most promising corporate managements. The consequences on the health of the economy would be immeasurably negative.

The allure of riding for free is indeed irresistible so long as it is legal but it diminishes gradually as more and more people ride for free and the quality of service declines in line with revenues. So if you want to plot the curve of passive funds value added vs. their market share, you can expect that past a certain threshold (well short of 100%), their increased dominance will be destructive and inimical to efficient capital allocation.

We can then talk about the hidden cost of indexing which is not incurred by people who invest in passive funds alone, but by everyone. This cost does not appear in the fund's prospectus but it impacts, or will eventually impact, the general functioning of the markets and of the economy. Then the hordes of investors who moved from active to passive funds will have felt very smart for a brief period until the economy suffers from large misallocations of capital. Here as with every investment, it was smart to be among the first people who switched to indexed funds, but as the crowd moves in, there will be diminishing returns, and ultimately negative returns.

It is a fair hypothesis that as the percentage of assets under passive management rises past a certain market share, the likelihood of a large market correction increases. Can investors in actively management funds find solace in the idea that at least their funds will outperform indexed funds in such a correction? Alas, no, not in the case of most long-only funds. Nearly all long active funds will underperform indexed funds under any plausible scenario. However, some well-managed hedge funds that are truly hedged may avoid losses or even do well in bear markets.

Perhaps then the right approach is to invest in indexed funds and to then exit the asset class entirely (active and passive) when all newspapers praise indexed funds on a daily basis. Would this be now, or soon?

So while it is hard to feel sorry for the active manager who underperforms and is usually overpaid, let us remember to be secretly or openly thankful that he is making it possible for the passive investor to 'ride the bus for free' and to also feel smugly superior about it.

P.S. As with everything else, taxes complicate the picture. Because a passive investor is likely to stay put for a longer time and to therefore benefit from compounding effects, his after-tax advantage over an investor in an active fund will be even greater than his pre-tax advantage over that same investor.

Disclosure: I am/we are long SPY, MDY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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