Latest knock to index funds

David Peartree, BridgeTower Media Newswires

The latest knock against index funds is that they may be dangerous. This year marks the 40th anniversary of the introduction of the first index mutual fund, making it an opportune occasion for critics to launch new attacks on an investment trend with undeniable momentum. The most recent broadside came from a report issued by the New York investment firm Sanford C. Bernstein & Co., “The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism.”

That’s a harsh comparison considering what an odious ideology Marxism has proved to be, but the author’s reference to Marxism was perhaps intended to sensationalize a claim that is otherwise too abstract to attract much interest.

Earlier attacks on the merits of index investing failed to persuade investors. When the first index mutual fund, an S&P 500 index fund, was introduced by Vanguard it was derided as “Bogle’s folly,” a reference to John Bogle, the founder and CEO of Vanguard. Index funds were deemed “un-American.” A poster that circulated at the time shows Uncle Sam with a stamp in hand and exclaims, “Help Stamp Out Index Funds,” and “Index Funds are UnAmerican.”

And why? Because index funds don’t try to do better than the market, they merely capture market returns, market returns represent the average return of all investors, and it is un-American to aspire to be just average. The original knock was that index funds offer investors mediocrity.

Except that four decades later study after study shows that the overwhelming majority of active managers underperform their market benchmark and that index funds produce better than average performance after costs. The latest claim, that indexing is worse than Marxism, was sensational enough to garner attention, and it worked. Bloomberg and other media outlets took notice.

The new claim is that indexing can distort stock prices and lead to a misallocation of capital in the economy. With index investing, money gets directed to stocks merely because they fall within a market benchmark and not because of their individual merits based on profitability or growth potential. Investors in index funds don’t consider the individual merits of the companies in which they invest. They are buying a broad slice of the market.

Stock pickers, on the other hand, only invest in a stock after assessing its merits relative to other stocks. The author argues that active managers serve an essential function by deciding how capital gets allocated.
Index investing, by ignoring the individual merits of each stock, can cause the market to overvalue bad stocks and undervalue good stocks. This can result in a misallocation of capital that may be harmful to the economy.

It’s an interesting claim, but it’s so theoretical that it’s hard to marshal any evidence to support it. It is true that active managers serve an essential function: Their trading activity sets market prices and promotes market efficiency. It is true also that index investing has grown to cover about 30 percent of the total U.S. market capitalization. The suggestion is that further growth in the market share captured by index investing may disrupt this price discovery process.

Everyone, including John Bogle, agrees as a theoretical exercise that a world where everyone indexed would not be workable for investors. Efficient price discovery would break down. Everyone also seems to agree that such an outcome is virtually inconceivable. Human nature is such that some astute investor would step forward to take advantage of an obvious disconnect between the stock prices and their true value. The unanswerable question for now is how much active trading is needed for the markets to remain efficient in setting prices for all investors. No one knows.

In the meantime, index funds may be growing their market share, but there is still plenty of active price discovery going on. Index funds may represent around 30% of the total market share, but that’s not the number that matters. “Active management’s share of trading is far higher than its share of assets, and it is trading that sets prices and drives market efficiency,” according to S&P Dow Jones Indices.

Active managers, meaning the stock pickers as opposed to the indexers, still represent between 90-95 percent of all trades, according to Vanguard.

Active management and index investing are joined at the hip. Active management certainly doesn’t need index investing and, in fact, would rather it just went away — but it won’t. One securities analyst was quoted 40 years ago saying, “I hope the damn things fail because if they don’t, it’s going to mean the jobs of a lot of good analysts and portfolio men.”

Index investing, on the other hand, needs active management to survive so that index funds can exploit the price discovery role that active management performs.

Theoretical concerns aside, the practical benefits of index investing are impossible to deny. Market returns are readily available to investors today at a very low cost, and that is a good thing.


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,