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Indexing's Effect On Value Investors

Andrew Ross Sorkin, in his DealBook column drew my attention to a recent letter from value investor Seth Klarman, well known in investing circles for two things: the wisdom he put forth in his iconic book Margin of Safety and his media reclusiveness.

Although he is speaking out largely to highlight the market's irrational "Trump rally," Klarman touches on a topic in which I've personally found much interest over time. Here is Sorkin quoting Klarman:

"When money flows into an index fund or index-related E.T.F., the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership)," he wrote. "Thus today's high-multiple companies are likely to also be tomorrow's, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings."

The move towards indexing is a worrisome and fascinating trend, and one to which I've given considerable thought.

My instinct has been that the primary result of the trend opens opportunities to wise investors who can take advantage of mispricings due to the market's overreliance on indexing. However, Klarman's framing of the situation persuasively suggests a dark side to the trend. Klarman is certainly making a self-interested argument in favor of active management, but his case, that as capital is absorbed by passive funds, remaining active funds are not large enough to correct mispricings, may increasingly hold truth.

Most obviously, this concern affects active managers themselves. These investors will not only see their assets under management decline, but will be less likely to see the result of their insights come to fruition. Part of Klarman's concern seems to be that a wise investment may never pay off because an undervalued stock will simply not be recognized as such by a wider over-indexed market.

But, the concern notably applies to society at large, as well. If Klarman is right, capital, to an increasing degree, is simply spread scattershot across the economy with no intelligent discretion. Undeserving companies, with poor business strategies, are favored equally to highly deserving companies, with wise and effective management. Although, to most Americans, the connection between the capital markets and the real economy is all but invisible, it is important to recognize the real economic waste that results from malfunctioning capital markets. It is this victim, of society in general, which deserves our real concern.

So, how much of a concern is it?

In extreme cases, Klarman's concerns will almost certainly not hold true. Despite the trend to indexing, companies nearing bankruptcy will continue to see their stock prices fall to near zero. Companies which are clearly minting money will continue to see their stock prices soar. It is difficult to envision a market which will not recognize the performance of exceptional companies. But, there is wide range of scenarios in the middle of the spectrum. There is a chance that we are entering a future in which investment mispricings become increasingly prevalent, but increasingly difficult to profit from.

Disclosure: I am/we are long SPY.