During the past 40 years, low-cost indexing has risen from an abstract financial theory with very few takers to a juggernaut sucking up most of the new money flowing into equity investments. BlackRock Inc., Vanguard Group Inc. and State Street Corp., the top three indexers, collectively own more than 10 percent of every company in the U.S. They own lots of overseas stakes as well.
This shift represents an existential threat to numerous parts of the financial services industry: Once investors decide to simply “buy the market,” many types of financial jobs are no longer necessary, from human traders to newsletter writers to various active management strategies.
I was reminded of this by a deeply flawed analysis, titled, “Your love of index funds is terrible for our economy.” It cried out for a response.
There are three reasons why indexing has become so popular. First, it costs less — often much less. High fees are a drag on returns; compounded over decades, they lead to a 20 to 30 percent penalty on total returns. Next, the alternative is active-stock or mutual-fund selection or some form of market timing. Academic research overwhelming shows that the vast majority of investors lack the skills or discipline to do that. Attempts at outperformance invariably lead to underperformance. Last, even among those who have the requisite skills, the discipline and emotional control necessary to successfully manage money is intermittent at best, absent at worst.
Back to the issue of index funds: The author identifies three reasons why index funds are an economic threat. Let’s take each of these in order:
“Index funds contribute to market melt-ups and meltdowns.”
Really? That statement is at odds with the experience of most Registered Investment Advisors (RIAs) and index-fund managers. Indeed, we have experienced several bubbles and crashes, melt-ups and meltdowns, during the past few decades. The evidence is clear that passive-index investors behave better than active-fund investors or market timers, tending to blunt rather than aggravate volatility.
During the financial crisis, passive investors sat tight and for the most part didn’t sell. Indeed, they were net buyers, according to former Vanguard Chief Executive Officer Bill McNabb. As my Bloomberg colleague Eric Balchunas pointed out, during the 2008 credit crunch, the money flows were into index funds and exchange-traded funds, in part because they displayed less volatility; more than $205 billion was put into these funds while active funds experienced $259 billion in withdrawals.
“Index funds reduce the quality of stock analysis.”
If this were offered as a joke, we could ignore it. But this is a serious — and a seriously flawed — allegation.Let’s be blunt: Stock analysis has been famously terrible for most of forever. Analysts are too bullish when things are going well; perhaps too bearish when they are not. They are highly conflicted. Since research itself doesn’t generate income, analysts are paid out the funds generated by other parts of a securities firm’s business, such as investment banking. Their goal is to encourage more active trading, which generates commissions but also higher tax bills and lower returns. For a reminder of how problematic Wall Street research is, recall the analyst scandals of the late 1990s and early 2000s.