If you read the Wall Street Journal, Barron’s, Bloomberg.com or any number of market commentaries over the weekend, you probably saw the ruckus raised last week by a research note from Sanford Bernstein, the NY brokerage firm, entitled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism.”
Kudos to the author, Bernstein strategist Inigo Fraser-Jenkins, on the attention-grabbing title, but as most commentary noted their argument falls short. Unfortunately, most commentators missed some important reasons why Fraser-Jenkins’ thesis has holes in it. Before we get to that, let’s review the premise.
The author contends that the growth in passive investing—a.k.a. indexing—threatens the efficient allocation of capital to the real economy, because a company’s inclusion in an index means it is guaranteed a certain percentage of investment flows, regardless of how well or how poorly management performs, or how promising or discouraging the investment opportunities may be. In contrast, active money managers (like Sanford Bernstein) help in the efficient allocation of capital by rewarding good companies and punishing poor ones.
Index investing is supposedly a threat worse than Marxism!
Under a Marxist economy, the research note contends, central planners at least attempt to direct resources to where society derives the most utility, but in a market where all or most investors are passive no one performs this crucial function leading to terrible waste and inefficiency. Voila, indexing is a threat worse than Marxism!
Since they brought it up, we’d venture that the Federal Reserve’s money printing and Dodd-Frank are bigger threats to the efficient allocation of capital than index funds. But they’re wrong about index funds for two reasons.
First, while it is true that index funds are growing rapidly, they hardly dominate the market. According to Investment Company Institute data, index funds (including both index mutual funds and ETFs) have grown from 5% of all mutual fund assets twenty years ago to 43% of assets as of the end of 2015 (Figure 1).
Figure 1: Index Fund Assets as a Percentage of all Mutual Fund Assets
Source: Investment Company Institute
While that growth is striking, that still makes them the minority of all mutual fund assets, and of course mutual funds are hardly the only market participants. Hedge Funds, large institutional investors and of course individuals are all active market participants, for the most part making active investment decisions.
The natural and interminable tug-of-war between active and passive investing ensures that neither will completely dominate.More importantly, while indexing could hypothetically at some point become so dominate as to threaten the efficiency of capital markets, the natural and interminable tug-of-war between active and passive investing likely ensures it never will. If passive investing were to start creating the kind of inefficiencies the authors fear, the rewards to the remaining active investors who exploit those inefficiencies would increase, and their outperformance would begin attract assets to active strategies.
The second shortcoming of the author’s case is that it equates all index investments with truly passive, cap-weighted indices. However, non-traditional “smart beta” indices that essentially codify the various active management strategies that authors approve of are the fastest growing segment of the index investing universe.
Of the 1,048 equity ETFs in our database, with almost $1.8 trillion in assets under management, just over half of assets are in what we would call truly passive, cap-weighted index funds like the S&P 500 SPDR (SPY), as shown in Figure 2. Another one-fourth are so-called “smart beta” funds that include style and fundamentally-driven funds such as the Vanguard Dividend Appreciation ETF (VIG). These funds do punish firms that perform poorly, because they drop firms that are unable to grow dividends (or whatever particular metrics the fund targets), while investing more in firms that succeed in these areas.
Figure 2: Breakdown of ETF Assets
Source: ETF Research Center
Finally, about one-fifth of assets are invested in narrow sector, industry and foreign country ETFs, some cap-weighted and some not. These can hardly be considered truly passive, “set-it-and-forget-it” investments. Investors rotate between sectors and countries based on their perceptions of the opportunities available, and thus are engaged in allocation of capital.
The growth of index investing has come largely at the expense of active fund managers, but that doesn’t mean we are at an economy-wrecking tipping point. To the extent that index funds have democratized and popularized investing, especially long-term investing, they may benefit economy. The millions of people who own them have more at stake in preventing meddling by one of the biggest threats to efficient markets: politicians!
What do you think? Will indexing be the death of capitalism? Do the authors at least have a point?