Indexing Is Making The Markets More Efficient - The Economist

by: Dale Roberts


Some investors blame passive indexing for a lot of things - including reducing price discovery.

The truth is, the markets are still actively priced and the active managers do most of the buying and selling.

In the US, more monies are certainly moving to index ETFs and that should spell the end for many passive managers.

If Darwinism has its way, it will be the inferior managers who are first to go leaving behind a smarter group of active managers.

There's no denying that index investing is an incredible force and trend. Indexing has changed the face of the investment world for the better, and is perhaps the greatest development for investors since that introduction of mutual funds. It's a revolution. It puts the power of and potential of investment markets directly into the hands of retail investors, for fees that are incredibly low. As we know, we can now buy a stock market index fund for as low as .03%. The traditional mutual fund industry cannot compete. It's very difficult for advisors to compete and add value. And given that reality, many advisors are also embracing index ETFs to create portfolios for their clients. The simplicity of creating index fund portfolios allows advisors to concentrate on areas where they can add value for clients, such as in the areas of education, coaching on investment behaviour, tax and estate planning and retirement funding models.

Given the threat of indexing to the active mangers, it's not surprising that indexing takes a lot of heat and gets blamed for "blindly" driving the markets higher or for eliminating price discovery. Many of these critics are certainly a little aggressive towards the passive. Price discovery of course is the process where the active managers will do an extraordinary amount of work to determine the 'correct' price of a stock on any given day, or at any given moment. Of course, that blame is all a ruse, the markets are still priced by those active managers. Here's my recent article Guess Who's Driving Those FAANG Stocks Higher. Of course the FAANG stocks are the popular tech combo of Facebook (FB) Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Google (GOOG).

On the subject of indexing and why it does not deserve the blame (and for support as to who prices the markets) here's Sorry, Indexing Is Not The Problem. On that front a few folks at The Economist agree, and in fact write that contrary to indexing removing some price discovery, indexing actually makes the markets more efficient. Here's The Growth of Index Investing Has Not Made The Markets Less Efficient. The subhead for that article reads ...

It has put a lot of bad fund managers out of business.

While not my original idea, I certainly embraced that concept early in my assessment of how the unstoppable indexing trend might affect the stock markets and active management. A smarter collective of active managers should certainly lead to 'smarter markets'. That seems like common sense. The percentage of active managers (monies) that are required to continue to effectively price the market compared to the money flows to 'passive' index funds is up for debate. Is there a tipping point where the passive money flows can distort the market? We'll see, and you can bet that no one is watching this, and studying this, more closely than the major index fund makers such as the BlackRock's and Vanguard's. They'll be the first to let you know.

From The Economist article …

Perhaps the growth of indexing has robbed the world of outstanding stockpickers. But it seems more likely that it has put a lot of bad managers out of business, just as Samuelson hoped. And it is not as if the buying and selling of stocks by informed investors with opinions has ceased. The turnover of stocks has actually increased over time. Active investors are more active than ever.

In the search for the next Apple, the market Darwinism is likely to continue to remove more bad apples from the active landscape. Of course the competition will be tough, there's a lot of underperforming bad apples - it's a big basket. And certainly any active funds with high fees are likely to put an added noose around their active neck.

Why do they bother? If the rise of index investing means less dumb money, then it is harder to beat the market.

I like that twist on the perception of what is smart money and what is dumb money. Dumb money is likely more to the side of paying an active manger massive fees over decades to underperform the market. That does not sound 'too smart'. We pay active mangers to beat the market, that's their job. That's the deal. As we know most active managers underperform the markets. Not getting what you pay for, but continuing to sign up for not getting what you pay for. Not smart. Of course, no country or group of investors is more guilty than Canadians who pay the highest mutual fund fees in the developed world, but continue to pile monies into high fee funds. That's why, in addition to writing for Seeking Alpha, I also launched my blog. Canadians, more than any group, need to understand what is smart money and what is 'dumb' money.

Another gem from that Economist article relates to my Driving the FAANG stocks article and premise.

Yet a concern that is often heard is that index investing helps to inflate bubbles, because index funds are forced to put more money into fashionable stocks even as they become more expensive. This rather misses the logic of indexing as a passive strategy. The index weights each stock by its value. If a stock’s price rises rapidly, its weight in the index increases. But its value in the indexed portfolio also increases. No buying is needed.

The author is right that many or most miss this simple mathematical or asset allocation weighting fact. The actual increase in the value of a company automatically takes care of the weighting in a cap weighted index fund. That event of course relates to current unit holders. The money flows to create new units of a passive index fund is certainly a separate issue, and once again, is being watched closely.

We'll also keep an eye on the disappearance of active funds, and the record of those bad apples. All told, I would take the position that the massive move to index investing is positive for those who embrace index investing and those who embrace or invest in actively managed funds. A smarter market is better for all. And of course, the ultimate irony is that the passive funds need those active managers. We need those stocks to be researched, and priced.

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Happy Investing.


Disclosure: I am/we are long AAPL, NKE, BCE, TU, ENB, TRP, CVS, WBA, MSFT, MMM, CL, JNJ, QCOM, MDT, BRK.B, ABT, PEP, TXN, WMT, UTX, LOW, BNS, TD, RY, BLK.

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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