Index Funds Are Parasites And Are Going To Kill The Market

15th Mar '13 by Edward Croft

32 comments 27445 reads

Everywhere you go these days you hear yet another investor singing the virtues of investing in low cost index trackers. Frankly the sales pitch makes sense doesn't it? It's very easy to understand and goes something like this:

"The majority of active fund managers underperform the market averages so why should you pay 2% for the privilege? If you buy an index fund you can guarantee average performance and thus beat the average fund manager."

It seems that this idea is winning. The mainstream press sings the praises of low cost passive investing, while the knives are out for active fat cat fund managers. Meanwhile a Tsunami of money in the fund management industry is flowing into passive vehicles, and the flow of funds into the big providers like Vanguard is quite astonishing. The advisory community is voting with its feet and has decided that index investing is the light.

But my nostrils have started flaring from a growing stench of groupthink and I can't help thinking that somehow this is all going to end in tears.

The ultimate piggyback ride

In a way, index investing is the ultimate piggyback ride on the coattails of the active management community. If you think about it, the selection of stocks that are included within the major indices is solely due to the discerning opinion of the active management community. These professionals bid the price of a stock up until it becomes a candidate for promotion to the relevant major index - such as the FTSE100 or S&P500. At this point index funds jump on the bandwagon and buy. The idea that this is a 'passive' process is beyond me - it's an active decision to ride on the coattails of other people's decision making.

The irony is that index funds haven't had to pay the salaries of the people who pick their stocks for them. Index investing has been monstrously successful partly due to the fact that through this trick they've kept the costs of management extremely low. If there were any justice index funds would pay a tax to the active management community for their service.

But piggybacking can only be a successful strategy if you don't get too heavy for your ride. As index investors have started to dominate the stock markets they have started to create some terrible unintended consequences. The horse's knees are starting to buckle.

When success…

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marben100

16th Mar '13

Hi Ed,

I support what you're saying but there are some facts that have to be faced (referring to the UK):

A large proportion of the population needs to be saving/investing, especially for retirement, so that needs to be encouraged
Only a small proportion of that population has the time, knowledge and inclination to invest directly in individual equities
A significant proportion (though < 50%) of direct equity investors that I come across (mainly on BBs) seem to me to be gamblers rather than investors - looking for a "fast buck" in some wonder-stock, rather than wishing to build a well-balanced portfolio for the long-term.

What are the implications of this?

We need good investment managers - but a) those managers need to accept a more reasonable level of fees for their effort and not to expect to become fabulously wealthy on the back of other people's money; b) we need those managers to be good stewards of the companies they take stakes in.
Education is important. It is certainly something we want to do more of at ShareSoc (subject to availability of resources) and I applaud your efforts via your excellent e-books.
The market for active equity investment support is limited - but nevertheless, significant.

I support your point about low-cost brokers. In many ways, the traditional private client broker model has much to commend it, as long as a) brokers were competent; b) their fees were reasonable. Obviously, low cost brokers have helped address the latter problem - but have they gone too far, and made it too difficult for discretionary brokers to operate? I guess that's a problem for such brokers/managers to solve: by demonstrating their worth, not churning portfolios (a fee model that doesn't benefit from churn would help), proving that they offer real value-added.

Cheers,

Mark

Roger Lawson

The Wurgler paper is certainly interesting but it ducks out of the question of how much of the market is actually held by index tracking funds, and hence what their likely influence might be. It tends to examine some of the distortions that index tracking might create without tackling the key issue. To my mind this is: what percentage of the market has to be taken by index trackers before the market becomes a totally artificial reflection of reality?
Consider the two extremes: if 100% of the market was index tracked, no fund manager would be looking at individual companies or their financial performance. Indeed market prices might be driven by the legendary "butterfly's wing" - a small random fluctuation in the price of a stock might cause it to temporarily rise, which would drive other funds to buy it, which would drive it further up via a continuing positive feedback loop. Likewise a random fall would drive it down. Indeed you would see the impact of “momentum” investing in extremis.
At the other extreme, where nobody is index tracking, every investor is making their own individual decisions about the merits of a stock. In the short term, given lack of any new news on a company, you might see the proverbial “random walk” where prices were driven by whether one investor got out of bed on the wrong side one morning, what another had for breakfast, what David Cameron or George Osborne has to say about the economy on the day, etc. When real news arose, you would see abrupt price changes as intelligent investors reacted to it.
Indeed you can perhaps see that in reality stock market prices are driven by a combination of investor sentiment, momentum effects, and fundamental news. As to what the proportions of these effects are in real stock markets is difficult to guess, but I suggest you can certainly see the impact of index tracking on those stocks that are more likely to be elements in the larger index tracking funds (e.g. FTSE-100 stocks), than in small cap stocks. The former seem to follow the “herd” instinct more than the latter.
Now it would be interesting to determine at what point index fund holding creates distortions in market prices by performing a simulation. One could simulate the behaviour of informed investors reacting to random news events, combined with a proportion of investors simply tracking an index. By varying the proportion of the “informed” to the “information-blind” in a particular run of the model, one could perceive how the market changed as index trackers became a larger proportion of the market.
Are there any academics out there keen to build such a simulation model? The results might be very informative because there is surely a danger that too much index tracking and too little intelligent investing might create an enormously volatile market.

FourSquare

This has been an elephant in the room for some time. But I had thought that as a then relatively small part of fund flows it would not be a problem. But if, as you say, it is now coming to dominate them, it becomes serious.

The whole point of a listed equity sector and a stock market is that investors are expected to direct capital towards the most efficient users of it. But if, as they have, they come to regard the market as a guarantee of future investment returns for their savings and pensions, the two do not necessarily go together (as the FSA among all its other inanities has failed to recognise)

If the stockmarket fails to perform this function for investors and users of capital, it will be an ideal excuse for a future government that is so inclined to nationalise it and abolish the stock exchange, arguing that it would be better able to direct savings funds where needed. It would replace equities as a vehicle for savings and pensions investment with a much expanded gilts market, to fund not only government but also industry (much as old Nulab wanted to do) and provide an alternative return for savings.

This is the inevitable result of the current trend, and another example of the financial markets galloping, blindly, towards the lemming cliff. (And also, some might say, of Gresham's Law in action)

Yet it need not be so. Only last November did research by Premier Asset Management (no relation) point up how the misleading methods used by the self-styled 'performance measurement' industry (relied on by the investment advisor press) inflated the apparent performance of index funds vs active funds. This comes about because their meaurement is of the mean performance of all funds, ignoring the effect of size - in other words it ignores the experience of the majority of investors. Premier calculated that when size was taken into account, the majority of investors in active funds experienced outperformance, across most sectors they examined.

This, of course, should encourge stock pickers to keep at it. Except that a continuation of these misleading performance indicators will undermine them.

Edward Croft

Hi Foursquare. I am of course deeply concerned about where all this leads.

Societe Generale have put out some stunning research in recent years to show just how correlated stocks are becoming in the market. The chart below is pulled from a SocGen piece illustrating that since 2000 equities have been getting more and more correlated with each other - it's the school of fish effect at work. The vast number of ETFs and index funds that slice and dice the market in every way are making it move increasingly as one.

Of course, I do believe that these things will have to balance themselves out over time, I'm just not sure how big the fissures will be in the interim.

17th Mar '13

One problem is that the FTSE is a totally misleading indicator. It should be split into just the top 10 or so companies (or 15 if you like) who totally determine its 'performance', and the remainder, who are generally more UK oriented and who have been performing rather differently. If this were done,along with more about the FTSE250 it might help to educate investors as to what exactly they are investing in. These indices were developed by actuaries for actuaries managing large pension funds assumed to be invested across the whole market. I think they are just as much an abomination in themselves as is 'index' investing.

dmjram

At current levels I'm not so sure this is a bad thing.

As Joel Greenblatt has commented, the more obsession there is with mimicking an index/institutional slavery to a narrowly defined datum and buying stocks regardless of their fundamentals, the greater the opportunities for individuals to outperform if they step back from following a market cap driven index and look at other factors which the majority of others have chosen to ignore. The fact that the S&P promotion effect endures is actually positive in this light, it shows that doing a bit of thinking can genereate superior returns and that as ever the EMH hypothesis continues to be found wanting when tested.

emptyend

But my nostrils have started flaring from a growing stench of groupthink and I can't help thinking that somehow this is all going to end in tears.....Could it be that passive investors are slowly killing the hand that fed them in the first place? That active investors actually underperform due to the growing load on their back? I can't help but hear the echo of Aesop's fables in this story - that index investors are killing the goose that laid their golden egg.

I haven't read through the other comments as yet (limited time today) but I must say that Ed's comments are spot-on as far as I am concerned.

I am old enough to have worked in the financial markets before Big Bang (1986) and before many of the modern innovations in computing power that has enabled the growth of "quant" businesses such as hedge funds, index funds and, indeed, the practical use of modern financial theories - such as the concept of stock-specific returns (alpha) and market returns (beta) both contributing to total return......

....and I very much agree with Ed that things have gone too far!

We have already seen, in 2007/8, the dire consequences wrought on the banking system from the misapplications of computing power tied to modern financial theories. Mortgage-backed bonds as presently understood would have been completely impossible to construct and manage before the mid-1980s. It is complete hogwash for people to suggest that "well this is all just progress" - it isn't....groupthink along those lines carries vast dangers!

Whilst employed in banking in the 1990s, I had a front row seat in the emergence of hedge funds, mortgage-backed bonds, the widespread use of short-selling and index-funds. I was also an extremely close observer of the growth of derivatives of all sorts from the early 1980s onwards.......

....and, with all of these innovations, I would say that the early adopters of these new technologies did indeed see substantial and meaningful rewards from their use. And I would also say that their emergence and growth initially provided a useful market function. BUT THAT WAS BEFORE THE TAIL STARTED WAGGING THE DOG! Consider these points:

Hedge funds initially invested in different strategies from the rest of the established markets. As a result they offered investors uncorrelated alpha and risk-adjusted superior returns - and made shedloads of money for their users....so much so that the "2 & 20" charging structure became a norm. This norm is now completely unaffordable, the returns are no longer uncorrelated - or exceptional - and in most meaningful respects hedge funds (and their closely-related index cousins) have become the market, due to simple weight of money and market dominance!
Index funds have preyed on the idea that "Joe Public" can't outperform the market and that his best hope is to reduce charges. As with hedge funds, there was plenty of truth in that for early adopters but, as with hedge funds, index funds have now come to dominate the market - and the result is that fundamentals have ceased to matter in their investment decisions. There is no human thought required for stock selection - the index funds simply buy any old crap at the price that "the market" has determined via its present groupthink-dominated weight-of-money processes.
Mortgage-backed bonds became a dominant financing channel in the late 1990s and early noughties for many financial institutions, especially for the likes of Northern Rock. We know what happened there when the market suddenly dried up as there was a sudden loss of confidence (caused by people suddenly recognising that there had been widespread fraud and mismanagement in mortgage-backed bonds, which had been exacerbated by bond ratings being willingly gamed via collusion between the rating agencies and the promoters of mortgage-backed bonds whilst the regulators were simultaneously completely asleep at the wheel). There is nothing wrong in principle with mortgage-backed bonds - but their central function was subverted by greed (including greed by investors who wanted 40 basis points more than other AAA paper paid!).
Derivatives are the basic building blocks that underpin all three innovations above, as well as the ready availability of short-selling. There is nothing wrong with derivatives either - providing that they are used in moderation.......but they very frequently haven't been!!! I have seen examples (going back as far as 15 years to before the LTCM crisis) where derivatives have been written that represented many hundreds of times the amount of underlying securities available.....and I don't doubt that the burgeoning growth of hedge funds and index funds has increased the prevalence of that in the years since I had first-hand knowledge! That is fundamentally dangerous - as well as being an obvious risk factor that can be identified by the use of simple common sense!

All these funds and instruments assume that the market is "God" and subsume the notion that market prices are perfect (in the technical sense!) - reflecting every piece of information available! BUT there is no material human input making that judgement on a daily basis and thus driving the flows of funds that ultimately are what determines prices. What should be merely "the tail" (providing balance to the whole dog) has now become the dog itself. The market is flying on autopilot - and that is incredibly dangerous for everyone in it! There are no meaningful checks and balances in the system of interlinked, computer-based trading....and there simply should be, otherwise we'll all be groupthinked into some other variety of financial brick wall with effects that may be even worse than 2007/8!

Rob Davies

Most people assume that passive investing allocates capital according to mkt cap. There is no reason that should apply to all passive funds and indeed the new breed of smart-beta funds give the asset class return but With other benefits.

cig

19th Mar '13

Regular (cap-weighted) index funds in steady state basically never trade, so they make fundamentals more reactive. People just seem to fail to understand the basic mechanics. For instance:

@kenobi: "companies in the ftse 100 are cushioned, from turbulence, so they won't fall so much on bad news, because the free float of shares is lower (with a chunk locked in tracker funds). I suppose equally when they go too high, they'll be pushed higher by purchases from the trackers"

This is totally upside down! The smaller free float means informed trades have more impact, in any direction. The lower the free float, the bigger the impact of any fixed quantity trade. There are no "purchases from trackers" as such, market cap trackers just hold the same number of shares and get the price impact *passively* in their valuation: individual stock weight increases/decreases with relative prices, with no trading.

Maybe flows into trackers can have some disruptive impact when they're big enough to dominate informed trading but it will reach steady state at some (if it's not there already) and then they will stop having an influence because they do not actively trade and the flow trades are a one off. It doesn't really matter if they end up owning 20% or 99% of the market, as long as it's non zero prices will be made. The main impact is on capacity: the higher the trackers' share, the smaller the amount required to move prices on the active pool.

I doubt the 9% premium to index entry arbitrage is really there (or we're all in the wrong strategy). I've not checked recently but it seemed much smaller in papers I stumbled on in the past. The volume of money involved is not big: outside of new issues/corporate actions where this arb doesn't apply, index entry/exit is at the bottom: a company gets out when it becomes the smallest company in the index and is replaced by someone just slightly bigger. It's a small/mid cap game with pretty restricted capacity.

That passive investing is freeloading on the work of active investors is basically correct, but then that sounds healthy: first, it puts a bound on abusive fees (why pay ridiculous money when you can get the average for free?), and it is also naturally stable, the pressure on fees takes some active investors out of the market making the work for the remaining ones easier. It's also an opportunity for small investors, as the bigger the passive players' share, the more "small cap"-like the active section becomes (the big players are taken out of the game due to sheer size).

Is there an index premium? Maybe, but then full market indices seems to behave similarly, and besides, this premium if it were to exist can be arbitraged by firms themselves: index firms can issue new shares until the premium is extinguished (overvalued shares = cheap money for issuers).

Good post in correcting one or two things but I don't agree with this argument:

That passive investing is freeloading on the work of active investors is basically correct, but then that sounds healthy: first, it puts a bound on abusive fees (why pay ridiculous money when you can get the average for free?), and it is also naturally stable, the pressure on fees takes some active investors out of the market making the work for the remaining ones easier. It's also an opportunity for small investors, as the bigger the passive players' share, the more "small cap"-like the active section becomes (the big players are taken out of the game due to sheer size).

The interaction between index funds and macro hedge fund strategies make it extraordinarily difficult for active funds to make money over the quarterly reporting timeframes that most are appraised on. Few institutional investors can take long-term "active" positions and the "weight of money" behind macro hedge funds and index funds (combined) is now such that active positions get no market traction.

If someone should happen to take a promising active position then, pretty soon, any outperformance will likely be dampened (and possibly eliminated or even reversed) by the macro/index funds autotrading the apparently-anomalous high price (or greater liquidity).

It seems to me that active managers are being asked to run sprint races with 100lb packs on their backs. They can't outperform on a quarterly basis when armies of computers are effectively playing mean-reversion games!

Here's a good post by Meb Faber about better indexing http://www.mebanefaber.com/2013/03/15/better-indexing/ With a great chart from O'Shaugnessy Asset Management

I personally think that more and more money is going to shift from index trackers to more appropriately weighted/picked indexes based on value, quality and other metrics. This is a trend in its nascency but we are seeing more and more of it... maybe I'll blog on it tonight.

The trouble is, that if a strategy that relies on a basic market inefficiency becomes sufficiently widely used, the inefficiency disappears, negating the effectiveness of the strategy.

Hence, past performance isn't necessarily a guide to future returns. Individual investors need to stay one step ahead of this game.

But we've known for 50 years that value wins as a strategy and it still beats the market... so I don't necessarily agree with you. Joel Greenblatt has pointed out that 50% of the top 10% managers over the last decade spent more than 3 years in the bottom decile of performers.

Value investing doesn't work all the time... and people (asset allocators) get bored and chase performance. In fact - the top performing fund of the last decade made 18% p.a. but the average investor in that fund LOST money.

That's why I do think a systematic value strategy is a great bet. It allies capital with the natural forces of the stock market - the gradual outing of value on timeframes that are inconvenient to the baying herd !

Interestingly on that topic, I once did the grunt work for a paper by Dimson and Marsh in about 1984 on "the small company effect" - which showed clearly that small companies outperformed. Almost as soon as the paper was published, the effect disappeared. It has appeared to reappear at intervals since then, though probably has only worked for 20-30% of the time AFAIAA (I no longer study it!).

My conclusion is, in essence, that you can always find a strategy that works by back-testing a few years data.....and you can devise a set of logical reasons why it should have worked.....but it won't last in the long term because it will either be competed away or some other fad will emerge to take over.

As Ed points out, value often works.....but then so it should - because "value" means buying stocks that are particularly cheap....and, importantly, stocks have generally followed an upward path over the last 80 years or so. A rising tide floats all the boats. But value didn't work very well (IIRC) for the 10 years from about 1997.......and cost several major value fund managers their jobs. First the tech mania and then growth plays were IIRC the place to be - and the perceived value universe was dominated by industrial dogs, failing retail formulas - and vastly over-rated banks!

The one area where the retail punter DOES have an edge is the ability to take positions that he can hold for 5-10 years without challenge (except from spouses ;-)). If you can pick long-term growth stories......ASOS, Apple, some oil shares etc........or even some undervalued stocks at the right time, then you can do very well indeed (I recall discussing Dunelm on TMF in early 2009, I think, when it was 150p ish - and it is now 800p+.....so I definitely should have done more than talk about its attractions in austere times!)

Whoah!

I'm not arguing against value investing. "Value" (in its broadest sense, including GARP) has and will always be at the heart of my own investment strategy. Au contraire. What I am trying say is that if a flood of money hits some specific value-based strategy (or a group of similar strategies), then chances are that that particular strategy will cease to outperform (except for a brief period when everyone piles into it, pushing prices up).

IMO, to succeed each investor needs to find an approach that differs from the herd, suits their own particular talents, and is resilient to their weaknesses. Sure, learn from others - learning is part of the joy of investing - but you need to find a style and methodology that suits you.

For those that don't have the time, inclination or knowledge to put in the grunt work necessary for successful direct investment, find a manager or (better) a set of managers that you trust to do so for you - and then give them the time to show their worth. ee's earlier comments about quarterly performance measurement are spot on IMO - and make my jaw drop. You cannot possibly judge a manager's abilities on anything less than a 3 year timeframe. 3 months is just ludicrous - and forces a manager to follow the herd, which makes their activities pointless.

20th Mar '13

Yes. Good post Mark - and sound advice.

I agree with that. And the time to experiment is when you have small amounts at risk - not when grandma has just left you her fortune. It is less easy to do than it sounds, though - and there is a need to be really honest with yourself......because there is always an alternative:

For those that don't have the time, inclination or knowledge to put in the grunt work necessary for successful direct investment, find a manager or (better) a set of managers that you trust to do so for you - and then give them the time to show their worth.

In my experience, the availability of time is the biggest constraint that most working people face. Even I don't directly manage my various (modest) pension pots other than by choosing fund sectors - partly because I took a conscious decision not to "have all my eggs in one basket". But you are also right that many lack the inclination or interest (including all of my children, to date (though they have time to come round to it)) - and they may also lack the knowledge.......

....on which topic I'd say that it is quite difficult to pick up the knowledge, unless you give yourself a long enough "run-in" to spend a couple of decades closely following markets, through all phases of their depressions and exuberances. The main thing to be guarded against is convincing yourself that you understand things when actually you don't - and that is a very easy trap to fall into!

Just been notified by Richard Beddard of Interactive Investor of a paragraph in the Kay Report that relates to this topic.

Quoting Richard (hope he doesn't mind!)...

Basically [Kay] is saying fund managers in general aren't good stewards because it's expensive. If you engage with a company and improve its profitability say, everybody benefits but you alone bear the cost.

Here's the para 5.34 from the Kay Report:

The structure of the industry favours exit over voice, and gives minimal incentives to analysis and engagement. Many respondents clearly regarded engagement with companies as a cost. One of the largest UK asset managers, with both active and passive funds under management, told us that “engagement with investor companies requires investment of time and resource which can be seen as an encumbrance in a situation where mandates are being awarded based on fees”. Many of these respondents nevertheless accepted that such engagement was a responsibility of the asset manager: some thought it should be paid for, as a distinct charge or a levy on all investors. A few respondents suggested that there was some evidence that activist fund managers could recover the costs of strong engagement through superior performance. This lack of incentive for engagement is an inescapable feature of an investment landscape characterised by a competitive fund management industry and the fragmented holding of shares. Many respondents commented that the increased dispersion of share holding had aggravated this problem.

This lack of incentive for engagement is an inescapable feature of an investment landscape characterised by a competitive fund management industry and the fragmented holding of shares. Many respondents commented that the increased dispersion of share holding had aggravated this problem.

I can't disagree with Kay on this - but it does point to the fact that the industry is characterised by having FAR too many fund managers - and that they are doing sub-standard jobs!

There is always a cost for the principals in employing agents such as fund managers - but to have a business model which simultaneously......

a) imposes charges on them for management

b) fails to conduct proper stewardship and due diligence in relation to the principal's assets and

c) subsumes into the process inefficiencies in terms of execution (such as lack of research access unless brokers fees are paid)

...is surely inviting more and more principals to take their management of their assets in-house!

Nobody should mind paying fees for a proper job that is done well and diligently - but too often it seems that fund managers want to cut corners and imperil their clients' assets......and that is surely not on in the modern age when real alternatives exist for principals at every level in the market!

Funnymoney

22nd Mar '13

Ed,

Thought you might be interested in this with respect to your composite value score/O’Shaughnessy
tweet. It contains some backtesting evidence (but not long enough, i.e. > 40years!)

http://www.value-investing.eu/en/Strategies/value_factor_one

Thanks funnymoney - valueinvesting.eu have some great backtesting data - am a fan of their work.

From a cursory glance, it looks based on the same Value Composite from the 4th Edition of O'Shaugnessy's book. We are already calculating something very similar to this but this is great reference material.

Planning on calculating composite scores across Value, Growth, Momentum, Income, Financial Strength, Earnings Quality etc - all across multiple metrics... not sure how or where we are going to publish them at this stage though...

Index funds are parasites and are going to kill the market

The ultimate piggyback ride

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Edward Croft

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