What If Everybody Became An Indexer? Financial Advisors' Daily Digest

by: SA For FAs

Summary

Sami J. Karam argues that passive investors are free riders whose behavior will lead the market as a whole to go out of business, i.e., crash.

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As a fund becomes populated with more investors, its component stocks naturally also rise in value. This phenomenon occurs on steroids with index funds, which continue to attract enormous inflows as their actively-managed counterparts progressively dwindle. The oft expressed fear is that index funds' popularity will eventually be their undoing, as their swelled constituents blow up spectacularly.

The passive investing phenomenon has attracted not just a surge of assets but a proportional surge of commentary. It is thus generally hard to find something fresh on this topic, and for that reason, we offer kudos to Sami J. Karam who conducts a sort of thought experiment questioning what would happen if everyone became a passive investor.

As Karam sees it, index investors are indeed outperforming their peers in actively-managed funds because they are "free riders." He writes:

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."

No need here for index champions to take umbrage at the term free rider. Karam acknowledges that it's a shrewd investment move, at least initially. But drawing his analogy out further, he expresses concern about how all this will end:

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."

That is what he thinks is happening to capital markets as assets swell because of their popularity rather than their superiority.

Numerous market theorists suggest that the pendulum will swing in the other direction because the momentum behind non-valuation-based trades creates inefficiencies for active managers to exploit. But what if active managers host a party to which no one shows up - because they're having too much fun at the indexing shindig?

Karam seems to think the last guys who show up to the bash are the ones who are going to crash:

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."

But here's a thought. When everybody runs off the bus screaming bloody murder, it is possible to remain calm, remain on the bus and wait for it to start riding again - still without paying the fare.

Let us know your take on this in our comments section. Meanwhile, today's advisor-related links: