By David Peartree
The Daily Record Newswire
After a slow start in the 1980s and 1990s, index investing has gone mainstream. It is now arguably the default approach for most individual investors and even for many institutional investors. Some observers see this as cause for concern.
Index funds now hold a majority of assets in certain fund categories and the trend line points to even greater use of index funds going forward. Looking back 10 years, only about 12 percent of all open-end mutual funds or exchange-traded funds were held in index tracking funds.
Now, over 27 percent of the dollars held in mutual funds or ETFs are in index tracking funds. In stock funds, the percentage of index funds is even higher, approximately 35 percent. In large-cap blend funds, a mix of growth and value stocks, nearly two-thirds of the invested dollars are in index funds.
There are exceptions, most notably in international stocks where most dollars are still allocated to actively managed funds. Still, the trend line across stocks and bonds clearly favors index funds. Morningstar reported that over the past 12 months inflows into index-tracking funds have outpaced inflows into actively managed mutual funds by a 2:1 margin. About 68 percent of net flows have moved into some form of index fund.
This trend has prompted some observers to pose the question, “What would happen if everyone indexed?” Vanguard, the mutual fund company, recently published a commentary asking,” Has indexing gotten too big?” In 2012, NYU professor Jeffrey Wurgler published a paper on “The Economic Consequences of Index-Linked Investing.”
Two questions are really being posed: 1) will the expansion of index investing create opportunities for active managers to outperform, and 2) will the expansion of index investing distort the financial markets?
To date there is no evidence that more index investing gives the remaining active investment managers a greater chance of outperforming the market. Less competition does not confer an advantage on active managers.
The distribution of U.S. stock funds across index tracking mutual funds and ETFs varies considerably. Figure 1 compares the distributions in 2003 and 2013. By 2013, 64 percent of U.S. large-cap core assets were held in index tracking funds but, at the low end, index funds made up only 6 percent of mid-cap growth funds.
If more index investing creates market inefficiencies or somehow confers a competitive advantage for active managers to exploit, the available data should be able to confirm this, but it doesn’t.
Since 2003 the S&P Dow Jones Indices has published semi-annual and annual reports known as the SPIVA report — S&P Indices Versus Active. SPIVA has become the de facto scorekeeper measuring the performance of actively managed funds against their relevant S&P index benchmarks.
The SPIVA report for 2013 demolishes the argument that more index investing in a particular category give the remaining active managers an advantage. The 2013 year-end SPIVA report shows that for the five-year period ending December 2013, two-thirds or more of active managers underperformed their benchmark.
In large-cap core funds, the area of the greatest use of indexing, nearly 80 percent of actively managed funds underperformed their benchmark. In mid-cap growth, the area with the least use of indexing, over 86 percent of actively managed funds underperformed. Figure 2 gives the results across all style categories of US stock funds.
There is no evidence that more index investing gives active managers a greater chance for superior performance. To the contrary, Professor Jeffrey Wurgler argues in his paper that the greater use of index investing may contribute to the underperformance of active managers. He cites evidence that stocks benefit from a price premium from being included in the S&P 500 Index and concludes, “the increasing popularity of indexing inhibits the ability of active managers to beat their index …”
But, to the second question, will the expansion of index investing distort the financial markets in other ways, less benign? Professor Wurgler believes that may be the case but quickly admits that the potential economic consequences are not well researched and may be difficult to measure.
He cites, purely as a hypothesis, the possibility that high frequency trading of index-based investments may have been behind the “flash crash” of May 6, 2010, when the Dow Jones Industrial Average crashed by about 9 percent within minutes. The causes of the flash crash, though, are still debated.
The arc of investment history may point to index investing but over 70 percent of assets are still invested in some form of active management. It is difficult to conceive of a future in which active management does not have a significant place. Human nature suggests that optimism and hubris will always lead a significant number of investors to believe that they have the knowledge and skill to outperform the market.
In the meantime, the risks of too much index investing may be speculative, but the benefits of efficiently capturing market returns at a low cost are clear and readily available today.
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David Peartree, JD, CFP® is the principal of Worth Considering Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.
