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Pragmatic Capitalism

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Is Indexing Just Another Wall Street Fad?

Here’s an interesting comment from value investor Seth Klarman on the rise of indexing (this is from 1991!):

klarman

Klarman is obviously biased because he’s in the business of selling a high fee asset management platform. If indexing is right then his form of highly active alpha chasing asset management is wrong. This is basically what Bill Ackman was saying when he lashed out against indexing earlier this year.

Anyhow, I think Klarman and Ackman are brilliant and I could never do what they’ve done over the years, but I did want to highlight some of the comments here because they’re common concerns that I don’t think are fully warranted.

SK: indexing is predicated on efficient markets.  

CR: No, this is one point I’ve reiterated in my repetitive posts on the myth of passive investing. Indexing doesn’t work because markets are efficient. Efficiency has nothing to do with it. Indexing works because the costs of active management are so high.  Bogle outlined this thinking back in 2003.

SK: The higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis.  

CR: This is the paradox of indexing.  Indexing, by definition, requires active management. In order for the passive indexers to remain passive they need active managers to make the markets that fulfill their indexing needs. There cannot be a world of only passive indexers.  So, if indexing is eating the world then there should be more opportunities for active managers in the form of market making and index arbitrage opportunities. Active managers like high frequency trading firms are flourishing in this world. Indexing doesn’t kill active management. It just forces it to change. And if Klarman is right, then he should embrace indexing as it could create more opportunities for more active managers to discover inefficiencies.

SK: If everyone practiced indexing….

CR: Nope, this is impossible.  Indexing requires active management to implement the various index fund strategies that exist.  Speaking of which, there are so many “indices” out there today that the whole idea of indexing has become rather nebulous. The indexing world is comprised of all sorts of different strategies that try to take advantage of different inefficiencies in the market. Index funds are just product wrappers doing exactly what Seth Klarman is trying to do in his hedge fund.  For instance, the Vanguard Value Fund is trying to capture the value premium by holding a specific set of stocks that meet a certain “value” criteria.  The only real difference between this index fund and Seth Klarman’s hedge fund is that the Vanguard fund is lower fee, more tax efficient and more diversified.

SK: “[Indexing] means that in a proxy contest, it makes no real difference to the manager of an index fund whether the dissidents or the incumbent management wins the fight”.  

CR: The vast evidence on the failure of active managers over the decades shows that public market investors don’t understand corporations better than managements. I don’t see how this evidence adds credence to the idea that we should want public investors to be even more active in the daily management activities of corporations….If anything, the failure of active managers means we should want public investors to voice fewer opinions about how companies should be run and instead of voting with their proxies, stick to voting with their wallets.

SK: I believe that indexing will turn out to be just another Wall Street fad.  

CR: Well, this was fabulously wrong. Indexing assets have exploded since 1991 as more active strategies have floundered.

aum

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