Seven mischievous scare stories about index funds and passive investing
Here are seven examples of popular myths about the growing popularity of passive investing that should be taken with a pinch of salt.
It’s out of control. Nonsense. Only around a quarter of global stocks are owned by index investors. Even in the US, where passive’s popularity is greatest, active management comfortably remains the default investing style. In large swathes of Europe, Asia and South America, indexing has barely made inroads.
It’s inflating the prices of the biggest stocks. This is not how indexing works. If the price of a stock rises, it's weighting in the fund increases automatically. The fund doesn’t need to keep buying more shares, or indeed sell shares in companies whose stock is falling. The vast bulk of trading — around 95% of it — is done by active managers.
It’s making markets less efficient. There is more price-setting going on today than there has ever been, with more than eighty million trades placed every day. That seems like a pretty efficient market to me. In any case, by forcing the worst-performing fund managers out of business, indexing is surely making markets even more efficient.
It’s causing the misallocation of capital. It’s true that allocating capital to the most deserving enterprises is an important function that active managers perform. But new public offerings account for only a tiny amount of trading. Most of the time, active managers are simply trading with each other.
It’s undermining corporate governance. Active managers’ record on corporate governance isn’t exactly impressive; look at their failure to control excessive boardroom pay, for a start. Passive managers, who have no choice but to carry on holding stocks and to work with company management, are actually better placed to make a positive difference. Increasingly, the evidence shows, they are bringing their influence to bear.
It’s going to go badly wrong when a correction comes. One of the most common myths about active managers is that they outperform passive managers when markets fall; the data clearly shows that they don’t. It’s also suggested that indexers will take fright and bail out when the long bull market finally ends, and yet exactly the opposite happened during the global financial crisis. In the US, active funds saw outflows of $259 billion in 2008, while passive funds saw inflows of $205 billion. In other words, passive investors behaved far better than active investors did.
It’s a danger to global capitalism. We weren’t even going to mention this one, but the 2016 paper by the active fund management company AllianceBernstein, Why Passive Investing is Worse than Marxism, has received so much attention that we feel we should.
Two things. First, indexers believe in the capital markets more than anyone; we believe that markets work and that, over time, they deliver fair returns to those who patiently invest in them. That hardly makes us Communists.
Secondly, indexing allows consumers to invest in far more stocks, far more efficiently and far more cheaply than ever before. Indeed, if anything, indexing is the very essence of capitalism.
Why the bad publicity?
So, why are these myths about index funds so prominent? And can we expect them to persist?
Larry Swedroe, the US investment author, summarised it neatly when he recently wrote: “Proponents of active management will continue to attack passive investing. In almost every case I’ve come across, these attacks not only are without foundation, they also are absurd and easily exposed as such. But that doesn’t stop them. The reason is simple: Passive investing threatens their livelihood.”
Remember, too, that it isn’t just active managers whose livelihoods are threatened by the growth of indexing. True, financial advisers are no longer allowed to receive commissions for the products they sell. But there are still many intermediaries with a vested interest in the health of active management; stockbrokers and investment consultants are obvious examples.
The bad-mouthing of index funds is set to continue.