Source: Stockopedia – Stock Market Research Network.
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 Samp;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 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 Samp;P500 index causes a 9% jump on average in the stocks price – but it doesn’t stop there. There is evidence that Samp;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 index groupthink 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“
Original Article: Index funds are parasites and are going to kill the market
