I often hear that indexing has become so popular that it is destroying “price discovery” – making it impossible for investors to know that they are paying a fair price for a security. Some say that makes indexing worse than Marxism. New research shows that this concern is unjustified.
In 1993, when Morningstar first began tracking index-versus-active assets, active funds had about 60 times as much in assets ($1.25 trillion) as index funds ($21 billion). As recently as 10 years ago, assets invested in index funds by retail investors were only about a third of those invested in actively managed funds: $1.87 trillion compared to $5.47 trillion. And by the end of the first quarter of 2022, Morningstar reported that retail investors had $8.53 trillion invested in index mutual funds, more than the $8.34 trillion invested in actively managed funds. Index funds have allowed investors to earn market returns while paying low fees – passive investors are “free riders,” benefiting from the research and analysis performed by active managers.
The dramatic rise in passive investing has not been without controversy – Wall Street has ridiculed it for years because it is the price discovery efforts of active managers that helps ensure that prices correctly reflect fundamental value. It is price discovery that keeps markets efficient. The following is just a small sample of the criticisms of passive investing I’ve collected over the years:
The common theme is that indexing (and passive investing in general) has become such a force that the market’s price discovery function is no longer working properly. Put differently, not everyone can index; someone must be active. That raises questions such as: Does the rise of index investing change information production in the economy? If so, does it affect the informational efficiency of stock prices?
Jeffrey Coles, Davidson Heath and Matthew Ringgenberg sought to answer those questions in their study, “On Index Investing,” published in the September 2022 issue of the Journal of Financial Economics. They used Russell Index reconstitutions as a source of exogenous variation in passive investing. Their sample period was 2007-2016. Following is a summary of their findings:
- After a switch in Russell index assignment, there was a shift in the composition of investors – when a stock switched into the Russell 2000 index from the Russell 1000, ownership by passive index funds increased by approximately 2% of its market capitalization, while ownership by active funds fell by a similar magnitude.
- More indexing causes stocks to have higher share turnover, higher short interest, higher volatility and higher correlation with index price movements.
- Using three different measures of information production – Google search volume, EDGAR page views from the Securities and Exchange Commission (SEC), and buy-side analyst reports – more index investing led to less information production about individual index stocks, with Google search volume falling by 3.8%, EDGAR page views by 14.1%, and the number of analyst reports by 10.8%.
- While shocks to the mix of passive and active investors caused significant changes in trading behavior and information production, those shocks did not alter the information content of prices – price efficiency remained unchanged. Across a range of measures of price informativeness, including anomaly mispricing and post-earnings announcement drift (PEAD), no effect was found.
- As the cost advantage of indexing rose, the number of indexers rose and the number of active investors fell. However, the fraction of active investors choosing to gather information stayed constant; and in equilibrium the informativeness of the price was determined by the ratio of active privately informed investors, who correct mispricing, to active publicly informed investors, who generate mispricing.
Of particular interest is the finding that higher short interest correlates with increased indexing – an increase (decrease) in passive investing led to a 1.9% increase (1.5% decrease) in short interest. It is intuitive because a significant part of many passive funds’ revenue stream is derived from lending shares they hold to short sellers. The increased supply of lenders lowers the cost of shorting, reducing the limits to arbitrage, helping to keep markets efficient.
Their findings led Coles, Heath and Ringgenberg to conclude: “Index investing does have effects on investment and information production. Nevertheless, the fraction and effort of informed investors adjust so that the relation between price and fundamental value is unchanged. In other words, the rise of index investing does not significantly affect market efficiency.”
Attacks on passive investing
Wall Street has attacked and ridiculed passive investing for decades. Among the arguments are that the rise of passive investing results in a reduction in price discovery efforts, leading to prices being distorted and capital allocated inefficiently. This occurs because indexing either has too large an influence on prices or it inhibits price discovery because it lowers aggregate market trading volume. The great irony is that if indexing’s popularity were distorting prices, active managers should be cheering, not ranting against its use, as it would provide them easy pickings, allowing them to outperform. (If money flowing into passive funds distorts prices, it could still make it difficult for active managers while it is occurring, as distortions could persist as long as the flow continued. Eventually, though, the opportunity would manifest itself.) But the rise of indexing has coincided with a dramatic fall in the percentage of active managers outperforming on a risk-adjusted basis.
It wasn’t until 1950 that the number of U.S. mutual funds topped 100. That number was still only at about 150 in 1960. And hedge funds were a nascent industry. At the end of 2021, there were 7,481 mutual funds in the U.S. and more than 3,800 hedge funds. Twenty years ago, hedge funds controlled about $300 billion. Today, they manage more than $5 trillion. Essentially, Wall Street wants you to believe that while 60 years ago the markets were operating efficiently with only about 100 actively managed funds, they are no longer functioning well when there are more than 10,000. All those funds are keeping markets highly efficient even though indexing’s share has dramatically increased.
As evidence of the declining ability of active management to deliver alpha, the study “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, which appeared in the Summer 2014 issue of The Journal of Portfolio Management, found that the percentage of skilled managers was about 20% in 1993. By 2011 it had fallen to just 1.6%. This closely matches the result of the 2010 paper “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” The authors, Eugene Fama and Kenneth French, found that only managers in the 98th and 99th percentiles showed evidence of statistically significant skill. On an after-tax basis, that 2% would be even lower.
Vanguard’s research team contributed to the debate on the negative impact of passive investing on the price discovery function with their March 2019 study, “A Drop in the Bucket: Indexing’s Share of U.S. Trading Activity.” To test the impact of indexing on price discovery, Vanguard measured not only turnover but also cash-flow-induced trading. Following is a summary of its findings:
- Despite the rise of indexing, total trading volume has been trending up.
- Since most indexing strategies have low turnover and trade at the margins of a large list of securities, their impact on trading activity and price discovery is minimal.
- Their base case yielded an estimate of approximately just 1% of all trading activity done by indexing strategies. Even under extreme assumptions, their estimates remained below 5%.
- Price discovery is driven by active market participants such as high-frequency traders (which account for about 50% of trading), hedge funds and individual investors.
You lose credibility when you try to claim that the segment of the market that accounts for between 1 and 5% of all trading activity is causing a distortion of market prices. Yet we hear this all the time. One example of this type of criticism was the article, “What They Don’t Tell You About Passive Investing.” Produced by Morgan Stanley, the thrust of the paper was that “the exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management.”
Investor takeaway
It’s hard to make the case that the price discovery function has been impaired – implying that securities are mispriced – when trading volume has been rising and the percentage of active managers that outperform has been on a steep decline for the past 20 years. Don’t be fooled by such criticisms. They all come from people and firms who don’t have your interests at heart. That is why they are not fiduciaries and fight to prevent being required to act solely in your interests. While passive investing may not be exciting, being a free rider allows you to achieve market rates of return in a low-cost and tax-efficient manner, giving you the greatest chance of achieving your life and financial goals.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country. Katie Keary, CFP®, CDFA® is an advisor with Buckingham Strategic Wealth.
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I often hear that indexing has become so popular that it is destroying “price discovery” – making it impossible for investors to know that they are paying a fair price for a security. Some say that makes indexing worse than Marxism. New research shows that this concern is unjustified.
