I used to be mildly amused by the myths emanating from the fund industry about the “dangers” of index funds. This is after all, the same industry that, in the run-up to the financial crisis, peddled products so lethal that the effects of their spectacular blow-up ten years ago are still being felt around the world.
Lately though I’ve started to find these passive investing scare stories increasingly irritating.
Particularly concerning have been recent articles by two respected journalists. First, in an opinion piece in The Times, the Sky News business presenter Ian King claimed that “the risks of passive funds will be cruelly exposed in any correction”. The article prompted the Bloomberg columnist Barry Ritholtz to write: “Every now and again, I come across a point of view that is so wrongheaded and misinformed that I am compelled to push back against it.”
I feel just the same way about last week’s article by Merryn Somerset Webb suggesting that the growing popularity of indexing would have left the economist Adam Smith “confused and possibly unimpressed”. In it she makes a series of assertions that are false and misleading and which demand a response.
Merryn talks about the rise of passive “forcing funds to buy more shares that have gone up and fewer that have gone down,” thereby making markets “increasingly inefficient”. This, emphatically, is not how index funds operate. If the price of a stock rises, its weighting in the fund increases automatically. The fund doesn’t need to buy more at all, and nor does it have to sell shares in companies whose stock is falling.
There is no evidence either that indexing is making markets less efficient. Indeed academic research suggests that markets are more efficient now than ever before. The volume of trading on global markets has grown so fast over the last 30 years or so that there are now more than eighty million trades every day. With each trade, buyers and sellers give their very latest, best-guess estimate of what a security is worth. That sounds like a pretty efficient market to me.
So, are index funds, as Merryn implies, “blindly” driving markets higher or lower? Absolutely not. The markets are still actively priced, and it’s active managers who do most of the buying and selling. True, the growth of indexing is putting some active managers out of business, but is it the smartest active managers who are going to the wall? Of course it’s not, it’s generally the worst-performing managers. In that sense, you could argue that passive investing is making markets even more efficient.
Merryn also suggests that index funds are causing “long-term capital misallocation”, and that this, in turn, “can only lead to lower productivity and lower long-term returns for everyone”.
Again, it’s a claim that doesn’t bear scrutiny. It suits active managers to suggest that, in directing funds to the worthiest recipients, they are somehow providing a vital service to UK plc. It is true that allocating capital is an important function they perform. But new public offerings account for only a tiny amount of trading. The vast majority of the time, active managers are simply trading with each other.
In reality, fund managers can make a bigger contribution to the economy through corporate governance, or holding company boards to account. It’s a responsibility, alas, that they haven’t taken particular seriously; just look at their failure to control excessive corporate pay, for example.
Passive managers, who have no choice but to carry on holding stocks and to work with company management, are far better placed to make a positive difference than active managers, who typically only hold a stock for a couple of years before they sell it. Again, recent academic research has shown that passive investing has improved governance and profitability, to the benefit of all investors, active and passive alike.
It is undeniable that index funds have hugely benefited consumers. By substantially reducing the cost of investing, they are delivering much higher net returns for those who use them. With the effects of compounding, investors who persist in using active funds can expect to lose around third of their returns in fees and charges.
I’m no expert on Adam Smith, but I do know that he cared for the interests of the consumer and was suspicious of monopolies and vested commercial interests. He would, I suggest, be “confused and unimpressed” by the continued dominance of active management, despite the overwhelming evidence that it has served consumers poorly for decades.
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