Index investing is a disruptive innovation from which private investors have fully benefited. They get more returns and at much lower costs. Moreover, academic studies and, of course, the annual surveys by Standard & Poors show time and again that simply trying to beat the market is doomed to failure.
Only a small proportion manage to beat the market, but over the long term very few active funds remain that consistently beat the market. Now we cannot all beat the market, because we are all market. At best, after costs, we can all keep up with the market. Now, thanks to the rise of index investing, those costs have changed. They have come down, not just for index investing, but for active investing.
It seems like a no-brainer
In the past, it was quite normal for an active fund to charge high fees, but for the portfolio to hardly differ from the index. In fact, the cost difference between active and passive investing is only reflected in the relatively small part that is actively invested. The effective cost burden is then so high that these funds are doomed to lag behind the index. Thanks to index investors, many active funds are now really active.
The success of index investing has attracted millions of investors. For years, money has been withdrawn from active funds, while there has been a substantial inflow into passive funds. The competition between index funds has ensured that the costs have steadily decreased, and there are now even index funds that do not charge any fees. Passive is therefore bigger than active. Meanwhile, investors in index funds save no less than 6 billion dollars a year in costs. It seems a no-brainer, you get the same exposure but for a tenth (or less) of the cost.
Yet it feels uncomfortable
Yet it feels uncomfortable. What is good for the individual investor may not be so good for the financial markets. There are market participants who consider index investing even worse than Marxism and the author of The Big Short called it a bubble. Even John Bogle (the founder of Vanguard, pictured) warned just before his death that the dominance of index funds might not serve the national interest.
More than a decade ago, at the Fund Event, I argued that if everyone started index investing, it would mean the end of capitalism. The uncomfortable thing is that such a statement evokes reactions from index investors who, with a religious fanaticism, think they have to preach the gospel of index investing. Incidentally, after that statement in 2010, I have always been a staunch supporter of index investing, as many people can attest, but I have always had problems with people wearing blinkers and only looking at the benefits.
The advantage also has a disadvantage
Index investors can also remain critical. There are also disadvantages, and these increase as the number of index investors increases. I was lucky enough to be able to ask Bogle how big he thought index investing should be before financial markets suffered the negative consequences. He said that 90 per cent would still be possible, according to toilet duck. Even if Bogle is right, that is of course not a binary event.
The strength of capitalism is that the free market is an optimal allocation mechanism for scarce resources. Financial markets represent a collective wisdom where the whole is stronger than the individual. All those individuals react to stimuli, new information is processed at lightning speed. Active investors act on that information. They sell one company and buy another. But there is less collective wisdom when a large proportion decides to invest in the index.
Quite apart from that, I will leave it to the stupid or the smart investors to invest in the index. In a world without active investors, most of the money goes to the companies that weigh most heavily in the index. In that respect it is worse than Marxism. In the centrally planned economy, bureaucratic officials at least tried to allocate resources efficiently. The disadvantage of a large group of index investors is that they are distorted by the price signal they send.
Index investing causes subtle price movements
A study of index investing in commodity markets shows that for companies that have to buy commodities, this causes a 6 percent increase in costs and a 40 percent drop in profits. Index investors cause subtle price movements, making it more difficult for market participants to assess when to buy or sell.
Index investing also increases the correlation between stocks in the index. Fortunately, index funds often continue to buy, no matter what, but there are indications that flash crashes are partly caused by index investors.
The main concern is that the large passive asset managers (BlackRock, Vanguard and State Street, better known as The Big Three) combined are often by far the largest shareholders. The moment these investors have a stake in every company in a certain sector, such a shareholder no longer has an interest in companies competing with each other. It is better to go for profit maximisation and for each company in a particular industry to raise its prices.
The ultimate incentive
Research into the importance of the Big Three in American airline companies shows that this causes tickets to become 3 to 7 per cent more expensive. Fortunately, it is not the case that the shareholders have pushed for this. Managers of companies like to compete, except when it turns out that the shareholder has an interest in the competitor. Also, do not underestimate the power of the Big Three. Not all shareholders turn up at a shareholder meeting, and together the Big Three almost always cast the deciding vote. Finally, index investing ensures that the Big Three get bigger.
The ultimate incentive for a CEO of a large company is to increase the weight of the company in the index. This leads to more mergers and takeovers. The result is that many sectors are dominated by a few large players, with all kinds of negative effects. It creates more inequality, less competition, rising prices for consumers, pressure on wages and it has become less easy for new entrants and therefore less room for innovation.
Fortunately, not all index investors are passive investors. Many index funds are used as a low-cost instrument by active investors. Furthermore, the rise of ESG scores means that many index investors have become active; they no longer look exclusively at the weight of a company in the index. Perhaps even the peak of truly passive investing is behind us and we are returning to investors who really care about the long-term prospects of a company.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws, Investment Officer Luxembourg’s sister publication. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear in Dutch in Fondsnieuws on Tuesdays and Thursdays.