The Indexing Bomb

Last week, I spoke at the Mississippi CFA Society’s annual forecasting event. It was one of the most pleasurable events I have attended. Don’t believe the negative hype on Mississippi. It’s an amazing place, and I would live there in a second. I am not kidding.

One of the things we talked about on the panel discussion was indexing. I can’t remember specifics, but I’ve probably talked about indexing in The 10th Man before. It is a bomb. Or more like a slow-moving electromagnetic pulse. Right now, 56% of all stock market assets in the US are passive, up from 50% a few years ago and up from 2% in 1999. In Japan, over 70% of all stock market assets are indexed.

You’ve probably heard a lot of active managers complaining about how hard it is to beat the index these days. It’s difficult to explain the mathematics behind it, even in terms a layman would understand, but just know the more the market is indexed, the harder it gets to beat the index. Which naturally increases the incentive to passively invest.

This is why I call indexing a bomb. Vanguard is a bomb. The more assets Vanguard gets, the more it lowers its fees, which encourages more people to send their money to Vanguard, which results in more money under passive management. It’s a self-reinforcing process that is not going to stop until the entire market is passive. And then what? What will happen next, when everyone owns an S&P 500 index fund? You basically own pure beta, and all the diversification benefits disappear. They have already disappeared.


One thing I like to point out to people is this:

When you invest in an index, you get the return of the index, but you also get the volatility of the index.