Index funds are parasites and are going to kill the market
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.
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When success breeds failure
There was an excellent paper written in 2010 by Professor Jeffrey Wurgler of NYU Stern School of Business that I highly recommend reading. He preaches that the stock market has only a finite capacity to absorb passive investment funds without materially and detrimentally impacting the market.
The wall of money investing in passive trackers is causing prices to detach from reality - inclusion in the S&P500 index causes a 9% jump on average in the stocks price - but it doesn't stop there. There is evidence that S&P 500 membership creates a price premium of 40% over non members. Many commentators, including the excellent blog at Psyfitec have warned of a looming 'index bubble', while Morck and Yang suggest that investing in these indices is essentially a "large cap growth and momentum strategy that can't last forever - this "index bubble" will pop".
But there's more, he suggests the whole market structure is creaking. When a stock is added to an index it's price action detaches from the rest of the market and it "begins to move more closely with its new 499 neighbours. It is as if it has joined a new school of fish". This accentuates gross price distortions and means that real valuations are less likely to be realised.
The delicious irony is that this creates an environment where large cap active fund managers can no longer harvest their expected returns from value situations. We've seen many great investors, even legends like Bill Miller, lose their way in recent years. 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.
Don't throw the baby out with the bathwater
Everybody should read John Bogle's classic "The Little Book of Common Sense Investing". His teachings on the 'relentless rules of humble arithmetic' and minimising costs are priceless. Passive investing has huge merits but there are perhaps better ways to do it than investing in the big market cap weighted index trackers.
In this respect, Joel Greenblatt's latest book, "The big secret for the small investor" is a great eye-opener. It preaches that many would be better off investing in equally weighted or fundamentally weighted funds. But even better than this is to build your own portfolio around solid and sound investment principles. Greenblatt preaches a mantra that we at Stockopedia stand by, that you can beat these index funds by creating your own low cost systematic investment strategy and investing directly in the underlying shares. We are building the tools to do this and believe fundamentally that it's a saner approach than the growing madness in much of the institutional money management world.
Further reading:
- FT Alphaville - "Did noone ever consider that index investing was dangerous"
- Psyfitec - "Hubble Bubble Index Trouble"
- Canadian Financial DIY - "Index investing victim of its own success"
but do you know where to look?
Get the most concise synopsis of everything that's been proven to work in value investing. If you like your stocks cheap you've found a treasure trove distilled to under 70 pages.
- How to find ultimate Bargain Stocks with Ben Graham
- How to spot Turnarounds and avoid Value Traps
- From Graham to Greenblatt via Piotroski & Lakonishok
- How to value stocks and set a margin of safety
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32 Comments on this Article show/hide all
yes, I can see this, except is it really the great wisdom of the investing community pushing up the valuation of stocks into the ftse 100 ?? or is it just simple multiples of profits and growth projections ?
If they are just riding on the coat tails of the managed funds, wouldn't they be wildly out performed by the managed funds ??
But I do agree as more and more money, a higher proportion that is, is in tracker funds, those that cannot sell, and are forced to buy even in the face of evidence, what does this do to the market ? It would suggest that 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, and when tracker funds fall, all these shares will loose this artificial boost.
Equally, when shares fall out of the footsie 100, they will fall disproportionally as these funds are forced to sell.
Does this create a double opportunity for investors ?
review shares falling out of the footsie, and buy on the fall as they leave if they are good companies,
and as always has been the case, but will increasingly become more, buy shares likely to enter the ftse 100 ??
every cloud has a silver lining,
K
In reply to kenobi, post #1
From what I am hearing kenobi, hedge funds are still making great money from playing the index promotion/demotion arbitrage trade. As quoted above - for the S&P 500 if the differential really is as much as 9% its no wonder why it's not been arbitraged away - the volume of money required would be too huge.
I've been really boggled by some of the things I've been reading this week and this was my output... I've always been a fan of Vanguard and have even encouraged many to invest with them, but am starting to have my doubts !
I think more than ever the great opportunities are off the beaten track - amongst smaller cap / non indexed stocks of course !
Hi kenobi,
But who decides what those multiples/projections should be? Without a strong community of active investors, there is no-one to determine valuations on any rational basis.
It's actually worse than that: this actually undermines the very foundations of capitalism and extends a creeping process of financial intermediation that has been going on for many decades. The basis of capitalism is that owners - shareholders - act as good, self-interested, stewards of the companies whose shares they own. They make sure that managers do a good job and don't steal the family silver.
If shareholders become disinterested algorithms, who is there to hold managements to account?
Debt is not the root cause of the malaise that western economies are currently going through, as some believe. Rather, it is a symptom of the real underlying causes. This is one of those causes.
Mark
You say: index investors are killing the goose that laid their golden egg.
It is the fund managers who are doing this, their generally poor performance and high charges have driven small investors into tracker funds.
Another factor is the hightened emphasis on dividend levels and lack of downside risk, this naturally favours the major components of the large indexes, rather than potential growth stocks.
Regardless of the causes, index trackers have attracted the herd and following the herd is a classic cause of bubbles.
In reply to marben100, post #3
But who decides what those multiples/projections should be? Without a strong community of active investors, there is no-one to determine valuations on any rational basis.
>> maybe the point is that the advice needed to cherry pick shares isn't worth the 2% or whatever these managed funds charge ??? and really the basic analysis should be afforded in a .75% managed tracker ????
If the managers were worth their 2%, they would outperform the trackers surely ?
I agree it would be a problem if say 90% of the funds in the stock markets were trackers, does anyone know what %age it is ??
K
"If there were any justice index funds would pay a tax to the active management community for their service."
Yeah - they could add this tax to the income streams they generate from lending their clients' stocks, the research commissions they pay for others to do their work and their already high fees.
In reply to kenobi, post #5
How would that work then? By definition, trackers don't do any analysis, all they do is maintain a portfolio of stocks that mirrors the constituents of an index.
I should hasten to add that in no way do I wish to defend excessive fund management fees - and ludicrous City salaries, in general. It is up to investors to vote with their feet and avoid funds/managers imposing excessive fees - but Ed's article (and my comments) highlights the dangers if everyone simply piles into index trackers.
Perhaps some active managers have been their own worst enemies through their rapacious behaviour? However, HgCapital Trust (LON:HGT) and RIT Capital Partners (LON:RCP) investment trusts, with shrewd, value-oriented, managers have been some of the best long-term performers in my portfolio, massively outperforming indices.
Cheers,
Mark
Someone rich buys a lot of shares and the price goes up. The trackers then buy a lot more and leverage it higher. Ditto vice versa. The market gets more volatile so even the professionals can't see where it's going next. Ed, I think you are right to raise concerns. Momentum trading adds to the problem similarly. Spiky share prices are of little use to anyone except the screen junkies and those who claim that liquidity is a good thing (because it suits their purposes). All this could be discouraged with a capital gains tax whose rate declines exponentially with the number of seconds a person held the stock, starting from 100% of profit tapering to about 0% at 3 years or so when people who actually have some interest in a company might drop out. If the gamblers don't like it, they can go to the race track.
Prof Wurler wants $5 to read his paper, so I won't be addressing his views.
I don't think there's anything destabilising about passive investing per se, and furthermore I think it's arguable that passive investors DO pay a 'tax' to good active investors.
Firstly I'll point out that index investing is not completely passive - it starts off with an active decision about which index you wish to mirror. And it's this active asset allocation decision that might pump up the S&P500. If this is happening, then presumably smart active investors enjoy outsized returns from eschewing the S&P500? And this is not a critism of passive investment but of dumbly following the herd choice of index in a bit of a Nifty Fifty way.
In the normal course of events, being passively invested means just sitting there doing nothing but holding x% of everything in your investment universe. No trading is happening so the passive investor is not distorting anything but just sat there enjoying the average underlying business performance whilst active traders move wealth from the dumb amongst their number to the smart.
Whilst I'd agree that passive investors do benefit from active investors setting prices sensibly I'd also say that new money entering a passive vehicle is being taken advantage of by smart active investors. Their money is going indiscriminately into the cheap and the expensive - and of course it's the smart active investors who're selling them the expensive (and the dumb who're selling them the cheap). Likewise on ultimately withdrawing their funds they're selling some stuff cheaply to the smart (and benefiting from selling some stuff expensively to the dumb).
In reply to marben100, post #3
I whole heartedly agree with these thoughts. These days new recruits are pointed by 99% of the media towards funds. The only discussion seems to be whether it is better to buy an ETF, Managed Fund or Investment Trust. Risk is offloaded onto Managers track record comparisons, and yet again the Nanny State of SAFE FUNDS undermines the need for investors to learn how to choose good stocks and manage their own portfolio.
In reply to Rapier, post #9
Rapier - sorry I posted the wrong link in the article - you can download it free at SSRN - http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1667188
In reply to pgbarlow, post #10
I think one of the great problems is that none of the online stockbrokers have invested in the kind of portfolio analytics and risk management tools that their customers need to more effectively manage the risks in their portfolios vs. investment funds. This is one reason why individuals in aggregate underperform the indices by something like 4-6% per year - I guess that's why the nanny state promotes diversified funds so much.
The brokers take a hands-off approach and just focus on best execution. Best execution is great, but they could solve this quandary and drive a huge amount more trading business by helping customers see where the risks are in a portfolio and helping them rebalance. I really don't think this is rocket science but requires some thought and investment - I think it would be win-win - both better returns/lower risk for the customer and a little more execution commission for the broker.
Anyway - our portfolio analytics aren't a fraction of where I'd like to take them on the website... but given time I hope we can solve this issue.