Building a portfolio to mimic a popular index may be the most creative, insightful and successful investment idea of the last 50 years. Born in academia, tested and retested by millions of investors, it is simple, cheap, effective and immensely profitable for those fortunate investors who have climbed aboard—and stayed aboard.
But if John Rekenthaler is correct, indexing's growing popularity may be accelerating far faster than anyone expected: In an early August column for Morningstar he reported that in the 12 months ended June 2014, nearly 70% of mutual fund and ETF purchases went into index funds.
The sheer immensity of the number just takes my breath away. In my lifetime, outside of a bubble or a panic there is no precedent for so many investors climbing aboard the same strategy at the same time.
This revelation alone could have been enough for some interesting commentary on my part. But it wasn't until later in Mr. Rekenthaler's commentary that he wrote: "As defenders of active management point out, investing can't become 100% passive because then nobody exists to set prices." Suddenly the stars aligned and I saw something I hadn't really noticed before. And that became the catalyst for this column.
The statement is, of course, totally correct. However, it is one portion of a very typical and popular narrative about indexing—one that is at best logically inconsistent, and at worst not a description of reality. The narrative goes like this:
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Indexing is the same as passive investing.
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Because indexing is passive, it is not part of the price setting mechanism of the market—that is done by active investors.
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Indexing can never become too popular because at some point it will cause the market to become inefficient. At that point active investors will exploit the inefficiencies, luring away enough investors from indexing to keep the market balanced.
Narrative Flaws
I have seen this in various forms dozens of times. But it wasn't until I read Mr. Rekenthaler's piece that I realized this flawed narrative, in concert with the sad state of affairs and perverse incentives in the investment management industry, is leading a majority of investors to conclude that indexing is actually their only sane and sensible choice.
For the record I have nothing against indexing. If anything I'm an admirer of the brilliant insight behind the idea. As an advisor I get paid the same whether I use an index fund or an active fund. But it is a law of investing that when something very successful starts to become too popular, past a certain point risks will form where none existed before. This (and only this) is the nature of my growing concern about indexing.
With that in mind, let's take a closer look at the indexing narrative:
"Indexing is the same as passive investing": We all know what passive investing looks like. Your 80-year-old uncle Bernie started investing when he was 18. Anytime he had some extra cash, he bought some shares of mostly blue chip companies, took the certificates and put them in his safe deposit box, where they remained untouched for decades. Uncle Bernie is now living on the dividends and his shares will be passed on to his heirs when he dies. That is passive investing.
In the early years of the advent of indexed mutual funds, one could legitimately claim that indexing, while perhaps not totally passive, was benign enough to be somewhere in the "passive adjacent" neighborhood. But the immense popularity of ETFs lured indexing away from that neighborhood a while ago.
"Indexing is not part of the price setting mechanism of the market": Market prices are set by one thing and one thing only: supply and demand. The aggregate behavior of all market participants creates supply and demand—and therefore sets prices.
