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The rise of index investing still spooks some investors - it shouldn’t

Brian Langstraat
— 1 minute read

Index investing’s sharp rise in popularity over the past decade or so scares some people. And not in a fun, haunted-house kind of way.

Brian Langstraat

They see a darker, more malign force expanding across the investing community – something they blame for creating a so-called passive investing bubble, for somehow distorting the market, and for being, of all things, un-American.

None of those hobgoblins are true, of course. But that they continue to be told and believed isn’t surprising. Change is hard, after all. And press reports in September about passive equity mutual fund assets overtaking active equity mutual fund assets in the US for the first time probably didn’t help allay anyone’s fears. So now seems a good a time to gain some perspective on what’s actually happening to investing – and what isn’t.

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Bursting the passive investing bubble

The headlines in September were all about index tracking US equity funds eclipsing their active counterparts for the first time – US$4.271 trillion to US$4.246 trillion, according to Morningstar. A somewhat notable milestone in investing history, to be sure, but a moment long anticipated. Was it also an indication of a dangerous bubble that will undermine the efficiency of capital markets? Hardly. 

It’s important to remember that, even with this symbolic changing of the guard, according to the Investment Company Institute, a trade association for funds, only about 17 per cent of the US stock market is actually held in index funds. Looked at that way, isn’t it possible that we’re seeing, as Robin Wigglesworth pointed out last month in the Financial Times, a long overdue deflating of an “active bubble” – one that “has expanded for nearly a century despite reams of evidence [and arithmetic logic] that most money managers underperform the market after fees”?

Does index investing distort prices?

In a word, no. If only 17 per cent of the market is held in passively managed index funds, that means the vast majority of pricing decisions are being made by – yep, you guessed it – active managers. This makes sense, and it will continue to make sense even if index investing grows to 60 per cent, 70 per cent, or even 80 per cent of equity market assets under management. Someone has to set prices, and in the equity market those someones are active managers. They argue about what to buy, what to sell, and when, and then vote with their dollars. Index investors merely buy into that consensus wisdom on the cheap, accepting the results that net out at the end of all those active bets.

In effect, the aggregate holdings of active managers comprise a market cap-weighted index. So if index investors are accepting the aggregate holdings of active managers, by definition index investors can’t “distort” the market. They’re simply “being the market.”

Active management isn’t going away

Few investors, especially in the high-net-worth space, are 100 per cent passive. They want portfolios that combine both approaches, with a keen eye for risk, fees, taxes, and performance that each approach, and a combination of both, can offer. 

But what seems to be changing is how clients approach their portfolios. Whereas 20 or 30 years ago investors may have looked at index investing as an oddity – an experiment – and warily allocated a small percentage of their assets to it, now that equation has flipped. Many are opting to start with a low-cost index-based allocation and then, if and when they’re convinced of an active manager’s skill, will carve out a portion of their assets to deploy in the hunt for alpha.

What could that mean in a world with more index investors? Quite possibly more opportunities for smart, skillful active managers. There are, and will continue to be, active managers capable of exploiting market and security circumstances to their clients’ benefit. But the tension between an active manager’s fee structure and its ability to deliver alpha above and beyond those fees (and taxes) will also persist. 

Is index investing more popular among investors? Of course it is

Investors and advisers for decades have been increasingly compelled by indexing’s overwhelming logic. But is it distorting the market? Of course not. And will it prevent active managers and financial advisers from earning a living? Certainly not. It has and will continue to reshape conversations about investing, asking advisers to think realistically and holistically about what’s best for their clients. For many, this is ultimately careful planning, a focus on risk and costs, and a varied blend of active and passive strategies. And at the end of the day that’s not so scary, is it?

Brian Langstraat, chief executive, Parametric

 

The rise of index investing still spooks some investors - it shouldn’t
Brian Langstraat
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