The Active Critiques: Indexing is Marxist, Mediocre, and Other Misguided Myths
The mutual fund industry has ridiculed index investing for decades. Strong, self-interested economic incentives to defend active funds has given rise to clever propaganda and fear campaigns which we scrutinize below.
• “Bogle’s Folly” (Bogle lived to see his index idea win in the market)
• “Anti-capitalistic mediocrity”
• “Worse than Marxism” Sanford Bernstein
• “Parasites on the financial system” (price discovery relies on active management)
• “If passive investing gets too big, the market won’t function” Goldman Sachs
In 2017, Morgan Stanley published an article titled “What No One Told You About Passive Investing,” which contended that the “exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management.” The studies above document over 90 years of data that suggests passive was long overdue to gain market acceptance based on its consistent outperformance.
Another twist on the same theme predicts a “reversion to the mean,” where active results will revert to a period of outperformance. The past ten years have been especially difficult for active “value” managers. The logic of mean reversion dictates value is overdue to outperform growth. That may prove true. But that doesn’t mean active value managers will outperform passive value managers. This line of reasoning also believes the move out of passive will be a destabilizing influence on markets. Selling will beget selling and there will be a perfect storm to the bottom.1Bob Rodriguez, “We Are Witnessing the Perfect Storm.” Advisor Perspectives, June 27, 2017. Yet when the market sells off, it sells everything – active and passive. There’s no consistent evidence to show active performs better during declines.
The Facts Speak Truth to Myths
Market Efficiency: In 1950 there were a total of 100 active mutual funds; in 1960 about 150 active funds. Today we have over 9,000 mutual funds and over 10,000 hedge (active) funds. Wall Street and index fund critics would have you believe that the market was operating efficiently with only 100-150 funds, but that market efficiency now suffers with almost 20,000 active funds?2Larry Swedroe, “Is Passive Investing Destroying the Markets?” Advisor Perspectives, May 16, 2018. That makes zero sense.
Price Discovery: One argument is that the rise of indexing reduces price discovery efforts, leading to price distortions and inefficient capital allocation.3Larry Swedroe, “Are Index Funds Destroying Market Efficiency?” Advisor Perspectives, June 10, 2019. It is true that active management plays a vital role in price discovery. However, to say indexing reduces price discovery is not in the evidence. Vanguard tested the impact of indexing on price discovery to measure its negative impact on price discovery.4Vanguard, “A Drop in the Bucket: Indexing’s Share of U.S. Trading Activity.” March 2019 study.
• Trading volume has trended up as indexing has gained market share. Most indexing strategies have low turnover, so their impact on trading activity and price discovery is minimal.
• Their base case estimated just 1% of trading activity is done by indexing strategies; under extreme assumptions it remained below 5%. Price discovery is driven by active market participants such as high-frequency traders (about 50% of trading), hedge funds and individual investors.
Conclusion: It’s not a credible argument to claim that a market segment that accounts for between 1% and 5% of all trading activity is causing a distortion of market prices.
Where’s the Debate?
The active critiques aren’t based on facts and they often obscure the consistence evidence of long-term studies.
Active managers won’t disappear. A select few managers have consistently beaten their benchmarks. The problem is in identifying these managers before they post the winning returns. Are they lucky or good? In any year, the odds of success in choosing one winning fund ranges between 10-30%. They decline toward 10% over longer time periods. Intelligent asset allocation diversifies across several funds and asset classes. You need to be right six or seven times! The odds for your success go from bad to worse with every decision. There’s no debating this statistical fact.
The active critiques are weak against over 90 years of market evidence. The consistency of the 2:1 loss-win ratio with the low payoffs for taking added risk, demonstrates how the risk outweighs the reward. Whereas, the data on indexing is clear and convincing: high-quality, low-cost index funds lower risk, minimize investment costs, and enables more of your money to work for your goals.
Jerry Matecun – Founder, President
Expert guidance to plan your future, preserve your lifestyle, and retire with confidence. For a confidential consult, contact me at jerry@compoundvalue.com.
FOOTNOTES
- 1Bob Rodriguez, “We Are Witnessing the Perfect Storm.” Advisor Perspectives, June 27, 2017.
- 2Larry Swedroe, “Is Passive Investing Destroying the Markets?” Advisor Perspectives, May 16, 2018.
- 3Larry Swedroe, “Are Index Funds Destroying Market Efficiency?” Advisor Perspectives, June 10, 2019.
- 4Vanguard, “A Drop in the Bucket: Indexing’s Share of U.S. Trading Activity.” March 2019 study.
PLEASE NOTE: Nothing herein constitutes investment, legal, or tax advice. For details please see Disclosure.
