"Indexing is not a tragedy of the commons.
It's a victory of the commons.
It’s a tragedy of the aristocracy."
– Patrick Geddes
Morningstar Inc. estimates that between 2013 and 2016, investors added nearly $1.3 trillion to passive mutual funds and exchange-traded funds (ETFs), and pulled more than a quarter trillion out of active funds. There is a lot of talk about the impact of this seismic shift from active to passive investing.
Those numbers have many active managers in a panic as they watch their profitable asset pools turn into what one banker has described as "large melting blocks of ice." A recent New York Times article cites a letter to investors from Boston hedge fund manager Seth Klarman saying he is concerned that the trend toward indexing could make markets less efficient at establishing prices.
"One of the perverse effects of increased indexing and E.T.F. activity is that it will tend to 'lock in' today's relative valuations between securities. . . . 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 inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become."
When we read articles like this, it gets us talking at Aperio Group, especially when we see financial incentives clouding the discussion. Here's a glimpse at a recent conversation among Patrick Geddes, Aperio Founder and Chief Tax Economist; Dr. Lisa Goldberg, Director of Research; and Pete Hand, Director of Quantitative Strategies.
|Q:||Do you think the trend toward indexing could make markets less efficient at establishing prices?|
Patrick Geddes: With technology and the instantaneous sharing of information, you don't need that much in resources allocated to price discovery to make an efficient economic system. A challenge with analyzing any drop in market efficiency is to determine the motivation of doomsayers predicting some comeuppance for indexing. We recommend that anyone reading about this issue check carefully regarding the effect on opinion makers of the potential revenue drop from the massive shift currently under way in the investment industry. (As a pro-indexing shop, of course we couldn’t possibly exhibit bias ourselves!) Motivations aside, further unbiased research would be welcome as to how much active management is required for good pricing.
Pete Hand: Price discovery comes from information being priced into market prices and typically comes from trading rather than holding securities. While there are many ways to measure volume, dollar trading in US equity markets is still greater than 200% of GDP. The trend toward indexing does not appear to have checked equity volumes or flow or assets into hedge funds, who may be the primary traders in equities these days.
On another point, does it strike you as odd that a hedge fund manager is worrying that there won't be adequate price discovery? Inadequate price discovery means that there should be greater inefficiency in the market and therefore more opportunities for alpha. It could, however, change the processes needed to capture that alpha. Is it possible that hedge fund managers are just worried there won't be enough dumb active mutual fund managers that they can pick off systematically? Or maybe they won't be able to count on followers bidding up their positions.
Lisa Goldberg: There is also the empirical question of what is behind the phenomenal growth of the US equity market, which surely contributes to the allure of indexing. As I wrote in a previous blog post, one of my favorite articles from J.P. Morgan shows that it has been a few winners that have driven the US index up, and most stocks have still been beneath the median. Active management has been hard because winners have been relatively rare.
|Q:||Is there any research to back up the idea that indexing makes markets less efficient?|
Pete: I think more research should be done on this topic; however, right now, I see this primarily as theory versus facts. It's a fact that investors are paying lower fees, while it is an open question as to whether there might be an impact on the efficiency of the market.
Lisa: I didn't find anything in the academic literature on how indexing affects price discovery. But there are some interesting academic discussions about how indexing affects markets. In his essay. "On the Economic Consequences of Index-Linked Investing," Jeffrey Wurgler describes index inclusion and exclusion effects on a security, as well as excess comovement of securities in the same index. He also talks about how the practice of benchmarking against an index may contribute to the low-volatility anomaly, arguing that a manager benchmarked against an index will tend to favor high-beta stocks.
|Q:||What is your perspective on what is happening?|
Lisa: It's hard to imagine that the trend toward indexing will mean people won't still chase after good ideas when they see them. Just look at the growth of Netflix at the same time that indexing has grown. This is happening in the face of all this indexing.
Patrick: Indexing isn't threatening to capitalism. It's capitalism in action because capital isn’t being missed by the new brilliant industries in biotech or whatever; that's working just fine. The capital allocation that is changing is it's not getting allocated to pay the investment industry.
|Q:||What do they expect people to do in response to this claim?|
Patrick: Behavioral finance says we think we are smarter than we are. The harm done by this behavioral bias is diminishing because, as investors, we are starting to wake up to the idea that maybe we’re not quite as smart as we thought. The investment industry is not giving people credit that they are smart enough to realize when they have a bad deal and they are shifting gears.
Lisa: It's ironic that active managers would expect individual investors to sacrifice their best interests to improve price discovery.
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