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Can Passive Investing Succeed Too Well?

In August 2016, the investment firm Sanford C. Bernstein & Co. released the provocatively titled report: “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.”

The report’s prediction was that, unless regulators and politicians took precautions, index fund growth could distort the financial markets and lead to massive mispricing of securities. Indexing is becoming more and more popular, the theory went, and if everyone chooses indexing, the system will break down because no one will pay attention to stock prices anymore.

While the alarmist tone of the Bernstein report may be an outlier, the firm is not the only one to worry about the growth of passive investing. Various groups and individuals have raised concerns about the overall impact of the growth of index funds in recent years. By their very nature, index funds do not set prices; they accept prices that active investors have set. If everyone invested only in index funds, no one would be left to determine securities’ value.

Evaluating this theory might be an interesting thought experiment for economists with too much time on their hands, but investors should not lose sleep over it. To understand why, it is worth discussing how index funds achieved their current popularity and the space they occupy in the broader equities universe.

A Short History Of Passive Investing

The basic idea of index investing was first employed by Wells Fargo Bank, which created a $6 million index account for Samsonite’s pension fund in 1971. That fund was intended to mimic the New York Stock Exchange, though its execution was described as “a nightmare.” Yet the attempt to implement indexing caught the attention of John Bogle, the founder of Vanguard.

Bogle, one of the most outspoken advocates of indexing to this day, launched the world’s first index mutual fund in 1976. At first, passive investment strategies appealed mainly to pension funds, which dominated indexing in the early 1990s. Individual investors, however, eventually began to recognize the virtues of index funds, as well. While active investment still outpaces passive overall, indexing has made significant gains in the past decade or so. As of year-end 2016, approximately $9.5 trillion was invested in active strategies, while $5.4 trillion was invested in passive strategies, according to data from Morningstar. In addition, according to Hedge Fund Research, assets invested in hedge funds surpassed $3 trillion by the end of 2016, so even as index funds grow more popular, they are not in danger of dominating equity investments in the short term.

But it is clear that index funds are not done growing. The New York Times reported in April that investors put $823 billion collectively into Vanguard funds over the past three calendar years, about 8.5 times as much as they invested with all of its competitors in the mutual fund industry combined. About $3 trillion of the $4.2 trillion in assets under management at the company is invested in passive index-based strategies.

Part of this change is a result of the struggles of active management in recent years, especially with strategies focused on large domestic companies. Between 2005 and 2015, 82 percent of actively managed large-company stock funds trailed the Standard & Poor’s 500-stock index, according to data from S&P Dow Jones Indices. According to Kiplinger, midsize and small-company stock funds under active management struggled even more compared with their relative indexes. When combined with the fact that passive mutual funds typically offer much lower fees, it is not hard to see why indexing has enjoyed a recent surge in popularity.

Why Massive Mispricings Are Unlikely In The Future

Even those who worry about the growth of passive investing generally concede that massive mispricings because of indexing have not yet arrived. But sincerely worrying that they might happen in the future ignores key realities of how the stock market works.

Despite the growth in index investing, plenty of active managers are still constantly trying to take advantage of security mispricings. In recent months, more than 150 million shares per day were traded in the United States alone, on average. While index funds represent a large share of stock market investment, they represent less than 5 percent of daily trading. With so much market activity on a daily basis, there is no cause for concern at this time with what investment professionals call “price discovery.” Price discovery is the process of determining the price of a security or other asset through the interactions of buyers and sellers. The greater the number of buyers and sellers, the faster and more accurate the process of price discovery. Those who worry about the growth of passive trading fear that too many index investors could warp the price discovery process.

Markets are cyclical, however, and if indexing continued to grow unabated, the system itself would prevent index funds from becoming large enough to create the disasters naysayers predict. For example, Bogle has suggested that, while chaos would indeed result if indexing completely dominated the market, such a scenario would need indexing to represent at least 75 percent of market share. Economist Burton Malkiel, another major proponent of index funds, set the bar higher, at 95 percent. Today, indexing represents about 35 percent of the market, so we have quite a long way to go to reach a tipping point.

In a 2016 interview on Bloomberg Radio, Malkiel also explained why hitting an indexing figure that high is inconceivable: “If in fact it was the case that markets were getting less and less efficient at reflecting information, believe me there would be a profit motive for somebody to jump in because if there’s a chance to make money in this world, that’s the beauty of capitalism, somebody will find a way to do it.” In other words, if indexing became massive enough for price distortions to become a real worry, mispriced securities would make it much easier for active managers to outperform the index.

Longstanding economic theory underpins the idea that, in a market where everyone has access to equal information, making the effort to obtain better information will pay off. This reality makes it almost unimaginable that active management could ever dwindle to as low as 5, or even 25 percent of the market.

For the time being, actual market conditions do not reflect what we would expect from an environment with too much indexing. In fact, we are seeing the opposite: Active managers and hedge funds continue to fail to outperform their benchmark indexes, largely because their higher fees create a difficult hurdle to clear consistently.

Some have attempted to liken the boom in index fund investing to a bubble. For example, they suggest that the 500 companies in the S&P 500 have been inflated because of huge S&P 500 index fund purchases. The 501st company thus would sell at a discount, because the index funds do not hold it, theoretically creating an opportunity for active managers. Today’s scenario is not a bubble, though; it is simply the result of the given circumstances. As more and more information becomes widely available and fees for active managers remain high, it is only becoming easier for index funds to outperform active managers.

At Palisades Hudson, we believe in the efficient market hypothesis: All publicly available information is baked into stock prices. Therefore stock prices are not only responding to index fund purchases, but to all other relevant information. Companies still release quarterly earnings and issue guidance for future earnings. Actively managed funds have simply come up against the reality of an efficient market, plus the long-term effects of their higher fees, not “too much” indexing.

If you need more evidence, consider the fact that while U.S. active managers continue to struggle, the story is not always the same abroad. For instance, while our firm typically recommends index funds for U.S. large- and small-company stocks, we do not recommend them in certain foreign markets, especially developing markets with less transparency, such as Latin America and Asia (excluding Japan). In these markets, active managers have had an easier time outperforming, because benchmark indices often include weak or struggling companies that active managers can more easily identify and avoid.

The pendulum has been swinging in one direction, but it may not continue this way forever. Right now, index funds are performing better than their actively managed competitors, but that does not mean this will always be true. The situation could change, either because active managers are forced to capitulate and significantly cut their fees, or because so much money pours into index funds that it really does become easier for active managers to take advantage of mispriced securities.

At Palisades Hudson, we periodically revisit the decision to pursue active or passive strategies for each asset class in which we invest, to make sure our recommendations are still appropriate in the current market environment. We typically recommend a mix of passive and active investments, since the best approach to different asset classes can vary. And we make changes to the recommended mix if we think the situation calls for it.

In the big picture, however, index funds are not “eating the world,” as The Wall Street Journal put it in a headline last summer. The growth of index funds in the past few decades has largely been good news for investors, and the stock market gives every indication of being able to handle the ongoing growth of passive investments for years to come.

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