Does indexing threaten the market?

Introduction

Index investing has grown significantly over the past 30 years. Back in 1990, few were even aware of the option for indexing, and options were limited mostly to a handful of conventional mutual funds tracking the U.S. S&P 500 index. In 1993, Boston’s State Street Global Advisors launched the first S&P 500 index-tracking exchanged traded fund (ETF), with ticker SPY. Today this ETF controls over USD$300 billion in assets. Thousands of other index-tracking mutual funds and ETFs, tracking numerous different indices, in numerous different world markets and regions, are now in operation; in the U.S. alone, there were 1716 ETFs in operation by the end of 2016.

In 2001, only 9.9% of U.S. equity mutual fund assets were held in index-tracking funds, both conventional and ETFs; by the end of 2016 the figure was 24.9%. Similar growth has been seen in other world markets. In addition to these figures, numerous institutional investors have announced their intention to devote larger portions of their funds to indexed investments. For example, CalPERS, the largest public employee pension system in the U.S., recently announced that it will increase the amount of its funds allocated to indexed investments. However, there are at present no firm figures on what total portion of institutional or international investment funds are indexed.

Advantages of passive (index-tracking) investing

There are, of course, several advantages to index-tracking investing:

  • Diversification. For individual investors, index-tracking funds and ETFs provide substantial diversification without the research, effort and expense required to construct one’s own custom portfolio of stocks and/or bonds. Indeed, for an investor with only a modest amount of savings to invest, it is plainly not possible to construct a diverse, broad-based portfolio of individual stocks and/or bonds. And there are psychological advantages as well: with a highly broad-based index fund, an investor need not lose sleep over bad news regarding one of the individual component firms.
  • Low fees. The expense ratios for actively managed mutual funds currently average about 1%; for hedge funds, the figure is typically 2%, plus 20% of any gains. By contrast, index-tracking mutual funds and ETFs typically feature very low fees. The expense ratio of SPY, the world’s most popular S&P 500-tracking ETF, is only 0.09%. The expense ratio for Charles Schwab’s SCHB ETF, which tracks the Dow Jones U.S. Broad Stock Market Index, is only 0.03%. Over time, such low fees make a huge difference in long-term gain, even if otherwise the performance is comparable.
  • Performance. As is now fairly well-known, the mid- to long-term performance of index-tracking mutual funds and ETFs is often greater than actively management funds, particularly after the expense ratio is deducted. In 2010, only 35% of actively managed U.S.-based equity funds outperformed their respective Morningstar benchmark; in 2016 only 25% did. What’s more, the popular index-tracking funds and ETFs also typically outperform most hedge funds. Such results have even led some large institutional investors to embrace indexed investing (see above).

With regards to performance, it is amusing to recall Warren Buffett’s recent ten-year bet with the manager of a fund-of-funds, pitting a S&P 500 index fund in competition with a basket of fund-of-funds. In the end (January 2018), it was no contest — the S&P 500-tracking index fund’s average annual gain was 8.5% (125.8% overall ten-year gain), compared with 6.5% (87.7% overall) for the best fund-of-fund among the five in the contest; on average the five fund-of-funds gained only 2.96% (36.3% overall).

Concerns about index investing

From the start, many have expressed misgivings about index investing, including the following:

  • Index investing may lead to market inefficiencies. Since index funds purchase securities without consideration of underlying fundamentals, the relative value of individual securities is not adjusted, thus potentially leading to significant market inefficiencies.
  • Index investing emphasizes certain firms and sectors. Since many stock indices, certainly including the U.S. S&P 500 and London’s FTSE 100 indices, for instance, are capitalization-weighted, a few large firms often dominate the total portfolio. In the U.S., four large tech firms, namely Apple (3.91%), Microsoft (3.10%), Amazon (2.70%) and Facebook (1.87%), constitute roughly 12% of the S&P 500. In Europe, four large banking, tobacco and oil firms, namely HSBC (7.73%), B-A Tobacco (5.28%), BP (4.92%) and Royal Dutch Shell (4.68%), constitute roughly 23% of the FTSE 100.
  • The good performance of index funds might be a self-fulfilling prophecy and lead to greater instability. There is concern in some quarters that the relatively good performance of index funds in recent years might be, in part, a self-fulfilling prophecy — individual investors buy such funds mainly because others have achieved good results from them. Similarly, in severe down markets, index funds are often dumped by individual investors in waves of panic selling. Thus a large passive fraction in the overall market might exacerbate instances such as the 2010 flash crash, due to a “blind leading the blind” effect.
  • Many new index ETFs might not be truly independent of the creation of the index. A 2012 Vanguard report found that the time gap between the publication of an index and the inception of an ETF implementing the index dropped from three years in 2000 to only 77 days by 2011. What’s more, out of 370 indexes for which the authors of the report were able to obtain reliable information, 87% of the indexes outperformed the broad U.S. stock market over the time period used for the backtest, but only 51% outperformed the broad market after inception of the ETF tied to the index, which is symptomatic of severe backtest overfitting.

It should should be emphasized that such concerns have been raised not just by doomsayers and jealous critics of the index world. Jack Bogle, the founder of Vanguard, of all people, has raised similar concerns: “If everybody indexed, the only word you could use is chaos, catastrophe. … The markets would fail.” At what level would passive funds be a danger? Bogle suggests 75%, but he did not present any data behind this figure.

Do index funds pose a threat in today’s markets?

So what are the facts here? Do index-tracking passive funds (indexed mutual funds and indexed ETFs) pose a significant threat in today’s markets?

One source of data is a 2001 article by Burton G. Malkiel of Princeton University and Aleksander Radisich of California State University at Long Beach. These authors studied the problem from three angles: (a) whether new money moving into S&P 500 index funds increases the differential investment return of the funds versus active managers; (b) whether inclusion of a stock tin the index appears to affect its valuation; and (c) whether the short- and long-term performance of stocks entering the index is affected by inclusion.

These authors concluded,

[T]he flow of funds into the S&P 500 has no identifiable effect on the excess return of the S&P 500 over actively managed mutual funds. This analysis suggests that the success of indexing has not been a self-fulfilling prophecy. … Our results [also] indicate that presence in the S&P 500 definitely does not increase the price of a stock; in fact, inasmuch as it has any effect, it tends to reduce a stock‚Äôs price-earnings multiple. … Overall, the evidence is that indexing has not inflated the prices of stocks in the S&P 500.

That study was published in 2001. Has the situation changed since then, given the large rise (9.9% to 24.9%) in indexed investing in the interim? In February 2018, Brad Steiman of Dimensional Fund Advisors Canada published an analysis that updated and extended some of the results of the earlier study.

In particular, Steiman asked whether indexing has led to a less efficient market. On this hypothesis active managers should, on average, achieve increasingly better results, by exploiting inefficiencies that are indirect results of indexing. To that end, he analyzed the average performance of actively managed U.S. funds from 2004 through 2016, relative to their Morningstar category benchmark (i.e., how many funds beat their respective benchmark). He found that this ratio has been remarkably stable during this period, mostly varying between 30% (in 2012) and 39% (in 2013); the only exception was in 2016, when the ratio was 25%. Needless to say, these data do not support the increasing inefficiency hypothesis.

Steiman also analyzed the extent to which S&P 500 stocks move in lockstep. He exhibited a histogram of the range of S&P 500 index component returns in 2017. These data varied very widely, ranging from +133.7% to -84.0%. Amazon was typical of the above-average gainers, with a 56.0% gain; General Electric was typical of the losers, with a 42.9% decline. Again, such a wide variation in performance refutes the claim that indexing has led to inefficient lockstep behavior of the S&P 500 component stocks.

Conclusion

There are certainly some legitimate grounds for concern here. After all, the investing world will always require at least some investors who address fundamentals, who continually reassess the value of a particular firm’s stock and bond offerings in light of current news, both about the firm itself and its competitive sector, as well as newly available big data sources, such as satellite data and AI-generated analysis. Clearly if a large fraction, say 75% or more, to use Bogle’s figure, of a market were passively indexed, that market would very likely exhibit significant inefficiencies (although such inefficiencies would lead to new employment opportunities for big-data-AI-savvy active managers and hedge funds who can exploit these inefficiencies!).

But from the above results and others, it does not appear that the current level of indexing is a significant problem. This assumes the 24.9% figure for index equity mutual funds and indexed ETFs as a fraction of all U.S. equity mutual funds. As mentioned above, there are no firm figures for institutional indexing or international markets, but it seems unlikely that overall indexed investments exceed the level of roughly 25%.

In any event, the question of index-generated market inefficiency is certainly worth monitoring. We will revisit this topic in future blogs as new data and research become available.

Along this line, we remain concerned about the fact that many new index ETFs might not be truly independent of the creation of the index, as mentioned above. Even more importantly, given that many of these ETFs and indices are designed via a process of computer exploration of many different component weightings, these ETFs are highly vulnerable to backtest overfitting. As mentioned above, a 2012 Vanguard report found that while 87% of newly published indexes outperformed the broad U.S. stock market over the time period used for the backtest, only 51% outperformed the broad market after inception of the ETF tied to the index.

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