Posts Tagged ‘index fund’

Index funds are parasites

Thursday, March 29th, 2007

Mr. Bogle, don’t take this the wrong way. Index funds are a great invention: they are simple, tax efficient, perform well, and push down investment management fees generally. All of these things benefit individual investors.

“Parasite” refers only to the fact that index funds benefit from market efficiency, while providing none.

Index funds track an overall market index by maintaining an appropriately weighted portfolio that mirrors the index. This performs well by riding the rising tide of the general stock market at very low cost.

But imagine if all equity capital were invested through index funds. Then index funds would comprise the entire market. No mechanism would exist for buying stocks below intrinsic value, and selling above intrinsic value. Markets would not be efficient, and stocks would follow a path that bore no relationship to value.

That imaginary situation cannot occur, because in the real world, “value arbitrageurs” always step in to restore market efficiency. But the fact is that index funds are nonmarket entities. Realistically, as index funds take an ever larger fraction of total market capitalization, a market distortion might begin to appear in the form of increased volatility.

Investors extrapolate. Thus, when markets have gone up recently, they pile into index funds, which then automatically buy stocks without regard to price. If this is done in sufficient volume, stock prices generally will rise to historically unusual price/earnings ratios. This creates a self-reinforcing state: rising stocks cause rising index investments, which cause rising stocks.

But individual investors also fear loss more than they desire gain. Thus, when a general market decline begins, redemptions accelerate. If index funds accounted for a large percentage of all stocks, and if price-earnings ratios were at historically high levels, then such a decline/redemption cycle could also be self-reinforcing. “Self-reinforcing decline/redemption cycle” is a very polite way of describing a market crash.

But that can’t happen, the efficient market theorist might argue, because the remaining non-index investors will simply arbitrage all that out, restoring efficient pricing. OK, let’s assume the theorist is right there. In that situation, who makes all the money? Hint: it’s not the index fund investor. Suddenly, they are on the wrong side of the efficiency equation. The arbitrageur makes the money by betting against the blind money going into or out of the market.

Thus it seems two things are true. First, index funds cannot grow past a certain point without ceasing to perform as they have. The change seems likely to emerge not as lower total returns, but rather as much higher volatility.

Second, for index funds to work, a mechanism of market efficiency must exist in the form of managed investments. That role might be small — perhaps only 10% of total market capitalization — but it must exist. And the larger the fraction of total capital under index fund management, the greater and more likely the distortion, and thus the higher the potential returns to traditional managed investments would become.

Thus, in the long run, index funds may actually benefit the few that remain as traditional investment managers.