INDEX INVESTING: COULD ITS SUCCESS BE ITS UNDOING?

8/23/14

The index fund bandwagon is getting more crowded.   Yours truly has been an ardent advocate of such passive investing (a term I don’t like much, even in connection with index funds, but that is grist for another mill) for 20+ years.  Warren Buffett, one of the few active managers who has managed to beat the indices over long periods of time, appears to have gotten on the bandwagon more recently.  (See the already seminal INDEX INVESTING:  “YOU (DON’T) GOTTA HAVE HEART…”, 8/21/14)  Now the Wall Street Journal’s Jason Zweig (“The Decline and Fall of Fund Managers,” WSJ, page B1, 8/23-8/24/14) reports that Charles Ellis, the founder of Greenwich Associates and an icon in the fund management industry, says that the day of the stock picker has passed and that

“With rare exceptions, active management is no longer able to hold its keep.”

There is something though, that we have to keep in mind when predicting or anticipating the demise of active management.  While this consideration is probably more valuable as an intellectual exercise than as a practical investment tool, it is worth pondering. 

If Mr. Ellis is right and, as a consequence, active managers (and, probably more importantly, active analysts) lose their jobs in large numbers,  fewer people will be doing the research they think will enable them to beat the markets and thus the mechanisms for information getting “into” the markets (i.e., to be reflected in securities prices) will get rusty.  The market will thus become less informationally efficient and thus the markets will get easier to beat, weakening one of the major arguments for index investing.  That will induce more people to invest their money with active managers and start the circle turning again, making the market more efficient and harder to beat and thus increasing the allure of index funds.  This is one of those self-correcting mechanisms that is endemic to finance and economics.

As I tell my finance and investments students, the great irony of the efficient market theory is that it only has validity because not everyone believes it.   If everyone believed the efficient market theory in its strongest form, no one would bother to do the research necessary to make the market efficient.

We certainly don’t have to worry about the world going entirely to indexing and thus destroying the efficiency of the markets, which is the very underpinning of index investing.  There will always be a lot of (primarily young and inexperienced) people who are certain that they can beat the markets; yours truly used to be one of them.  And we probably don’t even have to worry about a precipitous deterioration in the markets’ efficiency because of a sharp falloff in active managers and active management; there will always be legions of people chasing the dream of consistently beating the market.  But it is worth considering, from an intellectual standpoint if nothing else, the consequences for index investing of its own success.