Elon Musk, Marc Andreessen and Cathie Wood have spent the past few days on Twitter exchanging ideas about how investing and financial markets work — all in the name of liberating small-fry investors from elite giants that manage and peddle index funds.
Andreessen, a digital innovator who now oversees a venture capital fund, started things off with a critique of managerial bureaucracies and the rise of big institutional investors. He also decried large firms like BlackRock Inc. that advocate investing in companies with robust environmental, social and governance practices by leveraging other people’s money. He also highlighted his fears that BlackRock, Vanguard Group and other dominant firms that specialize in index funds had amassed too much power.
That last idea grabbed Musk’s attention. Tesla Inc.’s founder, who has solicited funds from big institutions so he can buy Twitter Inc., noted that “index/passive funds were too great a percentage of the market.” Vanguard and BlackRock also happen to be two of Twitter’s biggest shareholders. Wood, a celebrated active investor who rang up big gains in Tesla and other growth stocks but is now navigating rougher waters, lined up with Musk.
“Passive funds prevented many investors from enjoying a 400-fold appreciation in $TSLA,” she wrote on Twitter. “History will deem the accelerated shift toward passive funds during the last 20 years as a massive misallocation of capital.”
All of this dunking on passive investing and indexing would be more useful if it were true. And you have to wonder what the larger end game is for all of the smarties having this debate.
Whatever specters Andreessen, Musk and Wood want to raise about the growth of index funds at the expense of swashbuckling stock pickers, most of the money invested in stocks is still active. In fact, actively managed mutual funds and exchange-traded funds account for about 63% of the money in all U.S.-based stock funds and 82% of non-U.S. based funds, according to Morningstar. (And that doesn’t include all the money invested in stocks directly through brokers and trading apps such as Robinhood Markets Inc.)
When Wood contended that passive investing had caused “a massive misallocation of capital,” Musk responded with flotsam: “Passive/index investment is simply an amplifier of active investment. If active investment signal degrades in quality, passive is proportionately impacted,” he observed on Twitter. “Also, if there are very few actual active investors, their decisions can greatly increase company valuation volatility.”
While there isn’t perfect agreement on how much active investment is needed to keep markets functioning efficiently, the idea that markets could find themselves with very few active investors any time soon is delusional.
Nor is there support for the idea that passive funds represent a “massive misallocation of capital.” The implication is that active investors make better investment decisions than passive investors, but all the evidence points to the opposite conclusion. Vanguard introduced the first passive fund in 1976 tracking the S&P 500 Index, and it has beaten most active managers ever since. During the last 10 years, 83% of active managers underperformed the mighty S&P 500, according to S&P’s latest SPIVA report cataloguing the results of actively managed funds compared with passive indexes. Active managers fare just as badly relative to other indexes. If active managers are the best allocators of capital, they have little to show for it.
Nevertheless, Wood offers a familiar anecdote to illustrate why active managers are more adept: It took 10 years for Tesla to join the S&P 500, which meant that passive investors missed out on a big part of Tesla’s meteoric rise. Active managers were able to get in much earlier, to their advantage. After all, Tesla skyrocketed to a market value of $650 billion from just $2 billion during the decade after its initial public offering in 2010. Wood, by the way, didn’t miss out. She was an early investor in Tesla, and it remains the largest holding in her flagship fund, ARK Innovation ETF.
Wood fails to mention, however, that Tesla’s stock has also been hugely volatile and that investors often make bad decisions with volatile stocks, buying and selling at the wrong time and squandering their money in the process. High-flying stocks are often like roller coasters, and few individual investors have the stomach for it. Indexing, on the other hand, has allowed individuals to participate in markets – and diversify their holdings across style, size and geography in ways unimaginable a generation ago – without having to endure the white-knuckle moments that come with picking stocks.
Not surprisingly, investors in Wood’s actively managed fund, which is packed with stocks that swing wildly, haven’t fared well. According to a recent count by Morningstar portfolio strategist Amy Arnott, investors have put about $16 billion in Wood’s ETF since its launch in 2014, and current assets amount to about $10 billion. So while the fund has returned 19% a year since inception through March, including dividends, investors as a whole have lost money because they poured much of it in just before Wood’s fund imploded last year.
Compare that with how investors have fared in less volatile investments. Morningstar’s annual “Mind the Gap” report measures the difference between the performance reported by investment funds and the returns investors in those funds manage to capture. The results consistently show that more volatility leads to poorer outcomes for investors.
Presumably Wood is familiar with all of this data; perhaps Andreessen and Musk aren’t. If that’s the case, Andreessen and Musk have some more homework to do. It’s certainly important to ensure that indexing giants such as Blackrock and Vanguard don’t wind up with monopolistic market power, which is part of Andreessen’s argument. Andreessen is also a member of the investing and managerial elite he disdains, which he acknowledged in his own Twitter feed. Musk seems to be jumping into this discussion about indexing simply because he can, not because he’s well-informed on this particular topic.
Wood, though, offers a more troubling lesson. She can readily weigh her claims about indexing against reality. There is a wealth of data comparing the performance and impact of active and passive strategies. Wood chose, instead, to post sweeping and misleading claims about indexing when her own investments have been imploding. And in that context, it reads less like expertise and more like a smoke screen.
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Read more articles by Timothy L. O'Brien, Nir Kaissar
