MONEY mutual funds

Can Indexing Actually Grow Too Big and Fail?

As index funds are sopping up the world's investment dollars, an argument is emerging that this will eventually tip the scales back in favor of active managers. Don't worry just yet.

Indexing has always been a bit of a conundrum.

When this strategy — which calls for simply owning all the stocks in a market, rather than picking and choosing “the best” securities — hit Wall Street in the 1970s, it was regarded as downright “un-American.”

After all, why would any investor settle for the market’s average returns through indexing, when they could hitch their wagon to a stock picker whose goal is always to be above-average?

Well it turns out that over the long run, the vast majority of stock pickers aren’t consistently able to generate above-average returns. Part of that is because of the higher fees that stock pickers charge, which serve as a drag on performance. But another key element is the notion that markets are by and large efficient. And it’s very difficult for a lone stock picker to consistently outsmart an efficiently priced market.

Today, as indexing has transformed from a niche strategy to a widely embraced one — more than a third of the money invested in stock funds is currently pegged to a benchmark, thanks in part to the rise of exchange-traded funds — new questions about indexing are emerging.

Namely, if a plurality of investors switch from being inquisitive analysts digging for the truth about the long-term prospects of companies and instead throw up their hands and index, won’t the market become less efficient over time? Who would be left to sort the good stocks from the bad ones, so index investors don’t need to worry about it? And if that’s the case, won’t active managers start to gain an upper hand again?

Index investors often disparage active stock pickers for failing to “beat the market.” But this criticism gives active managers short shrift. The so-called market that portfolio managers can’t beat is made up of other active managers. It’s not necessarily that stock pickers aren’t good at what they do. It may be that the competition is so fierce that no particular active manager can consistently beat the consensus of his or her peers.

But as more and more of the world’s investors turn their back on stock picking and become indexers, that competition becomes less fierce.

This isn’t just an academic debate. This topic has grown sufficiently urgent that Vanguard, creator of the first retail index fund and one of the largest mutual fund companies in the world, saw fit to publish a response.

As far as theory goes, the notion that indexing’s popularity could one day alter the long-standing dynamics of the stock market isn’t totally crazy, notes Vanguard senior investment analyst Chris Philips. “It’s been an interesting intellectual debate,” Philips says. But he’s quick to add: “I don’t know if you can quantify if there is or will be a tipping point.”

One thing Vanguard is adamant about is that we haven’t reached such a point yet. While more than a third of mutual fund and ETF assets today are indexed, Vanguard asserts that a far smaller fraction of the overall stock market is in benchmark-tracking strategies.

While some institutions like pension funds use indexing strategies outside of mutual funds, even accounting for these holdings, Vanguard estimates only about 14% of money invested in the stock market is invested in index funds.

What’s more, if index funds were really driving a critical mass of portfolio managers from the market, the lessened competition would mean the remaining portfolio managers should do better. That hasn’t happened. Last year about 46% of active managers beat the market, according to Vanguard’s tally. (If you flipped a coin half would beat it in any given year.) That was up from about 30% in 2012, but about equal with the number that be beat the market in 1999.

This doesn’t mean the phenomenon couldn’t take place at some point in the future. But even if it did, presumably more would-be stock jockeys would try their hand at attempting to beat the market at that point, which would make the trick difficult again.

Vanguard’s Philips is skeptical that index investing will become popular enough to make that happen, at least not for a long time. “I’d be surprised if passive gets about 50% market share,” he says. That’s because Wall Street needs to make money and index funds are too tough a way to accomplish that.

“There is always going to be the search for an edge,” he says. “There just is not a lot of money in offering an index fund.”

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