One of the fundamental laws of investing is that when everyone agrees on something there is something important they are not seeing. There are few if any observers today who don't hold that indexing is as perfect an investment strategy as has ever existed: simple, cheap, effective, and with little to no downside (other than the market itself). Try Googling "risks of indexing" or any other permutation of the phrase. The results (or lack of them) are a powerful testimonial of how one-sided is our perception of indexing.
There is a robust intellectual, experiential and statistical foundation for this belief. Indexing just might be the most brilliant investment insight of the last 50 years. Yet hidden in the shadows of indexing's monumental success is a growing body of evidence that this truly elegant idea not only has the potential to threaten the stability of the market, but has already changed market behavior in ways few if any investors understand.
Historic Rise
For most of its life, indexing was a peripheral strategy with a market share rarely rising above the low teens. But over the last decade the popularity of ETFs has pushed that share to more than a third. The Financial Times reported last year that institutional indexing of U.S. equities could increase its market share to 50% as early as the end of 2014. Pensions and Investments recently reported that CalPERS, the largest pension fund in the U.S., had begun a five-month review of all of its investments to see if it is worth continuing with any active managers. And if CalPERS is considering it, you can be sure that they are not alone.
Up until now potential negatives from indexing were mostly academic observations. NYU professor Jeffrey Wurgler's 2010 paper "On the Economic Consequences of Index-Linked Investing" summarizes nearly 40 studies about indexing that go back as far as 1986. He shows us quite convincingly how and why indexing has been affecting the market and its components for decades.
When a stock becomes part of an index its behavior changes instantly. "It is as if it has joined a new school of fish," Wurgler writes. In summarizing the implication of all of these studies he turns the conventional wisdom about indexing on its head: "The popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average to beat the index; it may actually be contributing to their underperformance." If Wurgler is even close to being right, our perception of indexing may be due for a major adjustment.
Some observers have suggested that indexing will never become large enough to pose a systemic threat to the market because there will always be enough investors to offset the mispricing that excessive indexing might produce. However, in the real world extreme behavior in markets is driven by powerful forces and rarely has a benign end. I'm reminded of the quote, often attributed to Lord Keynes, that "Markets can remain irrational longer than you can remain solvent."
Wurgler notes that the more popular indexing becomes, the harder it will become for active managers to beat it. If that scenario plays out, and indexing continues to trounce active management, it would reinforce the growing conclusion among large institutional investors that their only sensible choice is to increase their exposure to passive strategies, setting the stage for an index-driven investment bubble (or if Wurgler's hypothesis is correct, exacerbating the one that has been in existence perhaps for years).
