Here’s an interview on CNBC from this morning wherein Robert Shiller argues that passive investing is a dangerous form of free loading. Now, I’m no Nobel Prize winner in economics, but I do raise chickens so I feel like I am fairly qualified to speak on this matter.¹ Let’s see if we can hash this out.
I’ve written about this a lot and for good reason. I work in an industry that has mastered the art of selling useless bullshit. And a big reason why that useless bullshit gets sold is because we don’t actually understand the things we’re talking about and we instead fall for whatever marketing slogan some guy on CNBC is using. The passive vs active argument is one of the most classic examples.
To start, we have to understand some basic first principles. There is, in the aggregate, only ONE market cap weighted portfolio of all outstanding financial assets. None of us replicate that portfolio perfectly because it cannot be replicated perfectly.² So everyone has to be at least a little bit active by deviating from this portfolio. In a strict technical sense, there is no such thing as a passive investor. Instead, we are all active to some degree. Low fee indexers are less active than stock pickers on average. But they are both actively picking assets inside the global financial asset portfolio. So it’s better to think of us all as active existing on a scale from smart active (like low cost indexing) to dumb active (day trading).
The second important understanding is that a less active investor (what Shiller is calling passive) needs a more active investor to make the underlying index work. For instance, when an index fund is purchased its price will necessarily change relative to the underlying basket of assets. If the price of the index rises above the asset value of the underlying basket then a market maker will sell the index and buy the underlying basket. They will buy that underlying basket from someone who is being even more active than they are as they buy the right quantities of each component. So, in order for an index to work you need a pyramid of more active investors to help make a market in the first place.
There’s two important lessons here from these first two points. Shiller is creating a non-sequitur when he ponders the idea that “everyone might index”. That is literally impossible. Second, Shiller does not seem to appreciate the fact that a less active investor (what he calls “passive”) needs more active investors to have a functioning index.
Thirdly, there’s an important lesson from that last comment. Shiller says indexers are “free loading” off of active investors. This isn’t true at all. Less active requires more active. And the less active investors are paying fees along the way in order for the index to exist in the first place. The classic example is when an index fund introduces new holdings. Research shows that the passive investors forego much of the gains that active managers earn when they bid up the price of that new entrant. In essence, the less active investor is paying a higher price to ultimately own that new entrant. You might not see the “fee”, but the less active investor certainly “pays” the more active investor for that new holding. The more obvious example is basic market making. An index fund market maker is earning a bid/ask spread all along the way as an index exists. Again, you might not see the fee come out of your pocket, but you are “paying” that fee in the form of higher prices. Lastly, indexers pay management fees to index fund providers for the economies of scale that they benefit from. This certainly isn’t free even though it’s low cost.
The fourth and last point I want to touch on has to do with Shiller’s concern that fewer active investors will mean that the market is less “efficient”. He says:
“[indexers are saying] the market is all knowing, but how in the world can the market be all knowing if not as many people are trying to beat it?”
The idea of efficiency” is messy to begin with.³ But the key point here is that this is not what indexers are saying. Indexers, all of whom deviate from global cap weighting, are explicitly saying that global cap weighting is wrong. They are picking specific components in low cost index funds that they feel are superior than the global cap weighted portfolio. Perhaps more importantly, what the less active indexer is saying is that they don’t know which securities are best so they will hold whatever a systematic index buys and sells in a low cost manner. While this might not beat the global cap weighted portfolio it will likely beat a more active strategy that this same indexer might try to implement. So, what an indexer is really saying is:
“I know I am not all knowing, but I do think the global cap weighted portfolio is wrong or inappropriate for me so I am going to buy XYZ index inside the global cap weighted portfolio because it will be a more efficient form of asset allocation than trying to pick fewer assets at what will probably be a higher average price.”
So, that’s that. It might not seem important, but if you think first principles are important (as I do) then this sort of stuff plays an important role in making informed decisions and tuning out the noise. This idea that passive investing is dangerous is, in my opinion, fully in the noise category. Anyhow, I’m just a lowly chicken farmer masquerading as a financial expert so I’ll get back to plucking eggs from the hen house. Let me know if you think Shiller is right in the forum.
¹ – For the record, being a chicken farmer does not qualify me to opine on anything financial unless you’re trying to quantify the cost of organic eggs.
² – This is due to several things – the market cap weighting is always changing due to new issuance. And the quantity of the outstanding assets is difficult to calculate and currently impossible to replicate using available instruments.
³ – The idea of “efficient” is a related but different debate about a word without a useful meaning in finance. “Efficient” doesn’t mean “right”. It just means that all information is priced in. Whether there are lots of “active” investors pricing in information or not is not necessary for having a market whose prices are right or wrong or even liquid. In fact, we should emphasize that prices are never right or wrong. There are two sides to every trade and someone in that trade is going to be wrong. Therefore, the price of an is always right and wrong depending on which side you’re on. More importantly, saying that markets price in all information is synonymous with saying that prices are prices. I see no use for this concept and I am uncertain why the financial industry is so infatuated with it.