Indexing is Not Worse than Marxism
I often hear that indexing has become so popular that it is destroying “price discovery” – making it impossible for investors to know that they are paying a fair price for a security. Some say that makes indexing worse than Marxism. New research shows that this concern is unjustified.
In 1993, when Morningstar first began tracking index-versus-active assets, active funds had about 60 times as much in assets ($1.25 trillion) as index funds ($21 billion). As recently as 10 years ago, assets invested in index funds by retail investors were only about a third of those invested in actively managed funds: $1.87 trillion compared to $5.47 trillion. And by the end of the first quarter of 2022, Morningstar reported that retail investors had $8.53 trillion invested in index mutual funds, more than the $8.34 trillion invested in actively managed funds. Index funds have allowed investors to earn market returns while paying low fees – passive investors are “free riders,” benefiting from the research and analysis performed by active managers.
The dramatic rise in passive investing has not been without controversy – Wall Street has ridiculed it for years because it is the price discovery efforts of active managers that helps ensure that prices correctly reflect fundamental value. It is price discovery that keeps markets efficient. The following is just a small sample of the criticisms of passive investing I’ve collected over the years:
- Sanford C. Bernstein & Co. strategist Inigo Fraser-Jenkins called it worse than Marxism.
- David Smith, fund manager at Hargreaves Lansdown, called passive investors parasites on the financial system.
- Tim O’Neill, global co-head of Goldman Sachs’ investment management division, warned investors that if passive investing gets too big, the market won't function.
The common theme is that indexing (and passive investing in general) has become such a force that the market’s price discovery function is no longer working properly. Put differently, not everyone can index; someone must be active. That raises questions such as: Does the rise of index investing change information production in the economy? If so, does it affect the informational efficiency of stock prices?
Jeffrey Coles, Davidson Heath and Matthew Ringgenberg sought to answer those questions in their study, “On Index Investing,” published in the September 2022 issue of the Journal of Financial Economics. They used Russell Index reconstitutions as a source of exogenous variation in passive investing. Their sample period was 2007-2016. Following is a summary of their findings:
- After a switch in Russell index assignment, there was a shift in the composition of investors – when a stock switched into the Russell 2000 index from the Russell 1000, ownership by passive index funds increased by approximately 2% of its market capitalization, while ownership by active funds fell by a similar magnitude.
- More indexing causes stocks to have higher share turnover, higher short interest, higher volatility and higher correlation with index price movements.
- Using three different measures of information production – Google search volume, EDGAR page views from the Securities and Exchange Commission (SEC), and buy-side analyst reports – more index investing led to less information production about individual index stocks, with Google search volume falling by 3.8%, EDGAR page views by 14.1%, and the number of analyst reports by 10.8%.
- While shocks to the mix of passive and active investors caused significant changes in trading behavior and information production, those shocks did not alter the information content of prices – price efficiency remained unchanged. Across a range of measures of price informativeness, including anomaly mispricing and post-earnings announcement drift (PEAD), no effect was found.
- As the cost advantage of indexing rose, the number of indexers rose and the number of active investors fell. However, the fraction of active investors choosing to gather information stayed constant; and in equilibrium the informativeness of the price was determined by the ratio of active privately informed investors, who correct mispricing, to active publicly informed investors, who generate mispricing.