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My “Wisdom” on Index Funds

Tadas Viskanta continues his series on “finance blogger wisdom” today discussing index funds. Specifically, he asks:

Should we care that the percentage of assets in indexes is on the rise, or should we just sit back and enjoy the (low cost) ride?

My answer was, um, not very thorough (again):

Indexing requires active management in order to maintain the “passive” allocation held by the indexers. The rise of indexing is good for both the technologically enabled active market makers and arbitrageurs as well as the passive indexers. It is, however, very bad for the high fee traditional “active” manager.

My views on indexing are simple. If you want low fees, tax efficiency and diversification then indexing is the way to go. As I noted in my new paper, I am an advocate of using market cap weighted index funds inside of a Countercyclical Indexing strategy. In other words, keep it simple, low cost, tax efficient, maintain an adaptive asset allocation across a fairly long time horizon and ensure your risk profile is in-line with your asset allocation as the markets evolve across time. But there’s also a lot of confusion surrounding indexing.  For instance:

1 – Stock pickers don’t like indexers and vice versa so there is a mythical line drawn in the sand across the “passive” and “active” battlefield.  But there’s a lot more overlap in this battle than people portray.  Someone who refers to themselves as a “passive” or “active” investor is like someone who wades into waist deep water and then declares that they’re “wet” or “dry”.¹  That’s not really how that works. The same goes for passive or active investing.  Someone who is being passive is reliant on active investors to make markets in the underlying instruments that the index fund owns. Further, there’s a lot more “activity” in a passive approach than some indexers seem to think (deviating from global cap weighting, rebalancing, contributing, distributing, how the actual index is managed beneath the surface, etc).  So, there’s a lot more gray area in this discussion than we generally assume.

2 – I’d argue that the more egregious confusion surrounds the idea that indexing might hurt the markets in the long-term.  The thinking usually goes “if everyone practiced indexing, stock prices would never change relative to each other because no one would be left to move them.”  This is something Seth Klarman, who is beyond brilliant, actually said and something I see consistently from smart people. It reminds me a little bit of all the smart people who get trotted onto financial TV talking about the “cash on the sidelines“.  It’s a total myth, but one that lives a big fat healthy life.

Likewise, it is literally impossible for “everyone to practice indexing”.  The reason is simple – passive indexers rely on active market makers and arbitrageurs to maintain the indexes.  As Rick Ferri, perhaps the most notable expert in the world when it comes to indexing says, “there’s no such thing as passive investing. It’s true. Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist.” Ferri goes on explaining that any index “must be continuously maintained by real people who face difficult issues when trying to track an index. The managers must make hundreds of active decisions each day concerning when to trade, what to trade, what to do with new cash, how to raise cash when needed, whether to use futures, swaps or other derivatives, etc. There’s nothing passive about managing an index fund.”

Bingo. Of course, as Rick rightly notes, knowledge is power.  None of this should deter indexers from using these products and benefiting from the many advantages that index funds offer. Indexing is great.  Unless you misunderstand it, abuse the products, misunderstand the products or fall victim to the many sales people hucking these products wrapped within higher fee packages under the veil of “passive indexing”.

¹ – Some people claim I am being overly technical when I talk about these matters, but I don’t think you can be overly detailed when it comes to finance and economics, industries that are cloaked in opaqueness and unclear thinking.