23 July 2014 | Indexing

If the wave of index products is any indication of how popular the concept of buy the market has become, it suggests a tsunami has hit investors. The contagious enthusiasm for indexing has cultivated a loyal following, including financial advisory firms dedicated to passive investment strategies. Yet such devotion has raised some red flags in the investment community. Some warn that the pendulum has swung too far in favour of indexing, and that it’s only a matter of time before it swings back to active investments.

We talked with Chris Philips, a senior analyst in Vanguard Investment Strategy Group, about what he’s hearing from advisors on this topic, and whether he thinks that indexing has gotten too big.

Why do some think that indexing is too big?

There are questions around the sustainability of indexing that pop up in several ways. In a nutshell, advisors want to know if we’re entering a period where it could be more advantageous for actively managed strategies. There are variations of the explanations, following roughly the same lines of reasoning.

One common thought is that, compared with active strategies, which ground investment decisions in research and seek to exploit perceived inefficiencies, indexing strategies can create market inefficiencies because of their indifferent approach to buying and selling. With this way of thinking, the more that assets flow to passive investments, the stronger their erosive force is on market efficiency.

In other words, the point at which indexing gets too big is when market efficiency erodes because of indexing’s growth. Market inefficiency creates opportunities for active investors to profit, and the thought is that the popularity of indexing will lead to a favourable environment for stock pickers.

Has indexing reached a tipping point in popularity?

First, let’s understand how big indexing is today.

The most common comparison is the number of passive versus active mutual funds. As of year-end 2013, index funds and ETFs constituted 35% of equity and 17% of fixed income open-end funds in the United States. 1 That seems significant; however, we know that mutual funds are only one component of investment markets.

How much do index strategies represent on an investable-dollar basis?

Index funds constituted 14% and 3% of equity and fixed income funds, respectively, in market-capitalization terms. 2 That means more than 85% of the equity market and more than 95% of the bond market were invested in some form of active management, be it individual securities, hedge funds or managed accounts.

I think we can safely say that there are ample players still in the ring fighting to outsmart the other side of the trade.

So what you’re saying is that even if active players represent a small population of investors, markets can still be efficient?

Investing is a zero-sum game being played among active investors, regardless of how many exist. For every investor’s dollar that outperforms the market, another investor’s dollar must underperform. It’s a key concept for how indexing works.

Prices are set and continuously reset by active investors seeking to execute on their information and beliefs. Indexers, on the other hand, attempt to passively track the market at the prices set by those active investors. Even if active investors made up a minority of a market in terms of invested dollars, as long as a profit motive existed, they would be jockeying with one another for any opportunity to make a gain.

As a result, the success of indexing, and why it’s gaining attention, is linked to cost and the mathematics of the zero-sum game.

Do you think the growth of index strategies is about to slow down?

No. We know that investors and advisors are voting with their feet. Lower costs help clients keep more of a fund’s return and are a big factor influencing relative performance. Even though index funds generally underperform their target benchmarks, low-cost index funds have displayed a greater probability of outperforming higher-cost actively managed funds. 3

Advisors recognize the significance of keeping costs low. Vanguard research shows that cash flows overwhelmingly seek out the lowest-cost investments. 4 Given the transition to fee-based practice models, the increased focus on cost disclosure and the significant attention the financial media have turned on cost, we don’t see this trend abating.

Back to the question of whether indexing’s indifferent buy the market philosophy is making the market inefficient. Are there data that answer that question?

One measure of market efficiency is the cost of executing a market transaction. If markets were becoming less efficient, one would see bid-ask spreads widen over time. However, when we looked at historical bid-ask spreads, we found that the average spread among stocks in the Standard & Poor’s 500 Index declined from about 7 basis points (bps) in 2009 to just under 2 bps as of March 31, 2014. 5 So the data are telling us no.

Are there additional data that suggest indexing doesn’t lead to market inefficiency?

We can look at how effective active managers have been in picking stocks and whether their fortunes have improved as the dollars allocated to passives have increased. In other words, if the rise of passive funds were leading to inefficiencies because of the dumb money that was information-ignorant, theoretically, active managers should have an easier time outperforming a relevant index.

However, as the dollars allocated to passives have increased, the relative performance of active managers has not followed suit. A simple example to be sure, but sometimes the simple ones best prove (or disprove) a point.

What about informational efficiencies? Won’t more money decrease the quality of information reflected in stock prices?

Information represents a hurdle to accurately pricing assets, causing market prices to be inefficient, or wrong. The market’s efficiency depends on how informed the active investors are.

Like bad information, misinformed investors tend to increase market inefficiency, while informed or skilled investors tend to make the market more efficient.

Numerous other factors, such as technology, play a big role in information discovery and price efficiency. The rapid pace of innovation in capital markets, technology and communication is making the game even more competitive among active investors.

Arguably more people than ever have more access than ever to information and technology. This suggests that market efficiency should be better now than ever before, regardless of how much the market is using index strategies.

Active investing is a competitive game that favours the savviest, most informed and most able to execute a trade efficiently. Every investor has a different edge, and the interplay among profit motives, active investors, the zero-sum game and indexing is what makes this dynamic possible.

Some argue that the rise of indexing has actually made it more difficult to be an active manager. Can you explain?

This discussion gets to the idea that as passive grows, stock correlations increase, meaning it’s more difficult for active investors to differentiate their portfolios from the market and, therefore, outperform. It’s important to understand how the correlation statistic is being calculated. Different time periods and different methodologies can result in very different answers.

For example, using the last 126 trading days of each calendar year from 2006 to 2013 as the measurement window, Vanguard found that the average pairwise correlation was as low as 18% in 2006 and as high as 62% in 2011, with 2012 and 2013 clocked in at 33% and 25%, respectively. In fact, 2011 was the outlierthe next closest was 2008 at 49%.

A second methodology used rolling 63-day correlations and found no systematic pattern of rising correlations year to year or within a given year. All in all, it really isn’t about the correlation!

What if every investor indexed?

That’s a simple question with a complicated answer.

In theory, an all-indexed market would be very inefficient because there would be no mechanism to establish a continuous market price for securities. But that inefficiency would then create opportunities, at which point active traders would jump back into the market to take advantage of them.

In practice, it’s inconceivable that a market would ever get to that point.

Note:

All investing is subject to risk, including the possible loss of the money you invest.

1 Morningstar, Inc. as of March 31, 2014.

2 Morningstar, Inc. as of March 31, 2014.

3 Christopher B. Philips, Francis M. Kinniry Jr. Todd Schlanger, and Joshua M. Hirt, 2014. The case for index-fund investing. Valley Forge, PA: The Vanguard Group, Inc.

4 Francis M. Kinniry Jr. Donald G. Bennyhoff, Yan Zilbering, 2013. Costs matter:  Are fund investors voting with their feet? Valley Forge, PA: The Vanguard Group, Inc.

5 Morningstar, Inc. as of March 31, 2014.