Indexing Is Capitalism at Its Best
A recent Sanford Bernstein research report titled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism,” besides starting quite the kerfuffle in the financial world, raises some eternal questions. For instance, if you stumbled upon any random group of finance Ph.D. students at 2 a.m. in the student lounge having finished all the Michelob Light they lifted off the MBA mixer, there’s a good chance you would hear one of them say, “Hey, if everyone indexed what would happen?” and then witness a long but ultimately unproductive discussion on the topic. More subtle, alternative versions of the question would be: What’s the right amount of active management for investors and for society in general (and is the answer the same)? What’s the fair fee for such services? How efficient are markets? If markets are not perfectly efficient, and they most assuredly are not, what’s the efficient amount of inefficiency? Do correlations go up as a result of indexing?
These are all good, fun and important questions, but I won’t be addressing them here (much). Instead, my goal is much simpler. The Bernstein note missed, or at least minimized, something much more important about prices. Free riding on price signals isn’t a bug of capitalism to be exploited by those greedy red indexers; rather, the use of price signals by those who played no role in setting them may be capitalism’s most important feature.
A central complaint hurled at indexing has long been that it piggybacks on the work of others. Others -- in this case, skilled stock pickers -- put in the work to set accurate prices. Then the free riders come in and use these prices themselves without putting in any work at all. The shame!
What is left out of these complaints is that this isn’t something specific to investing or active management. For most of the goods and services we all consume, we naturally rely on existing market prices that we made no effort to determine ourselves. Some of these prices come out of an implied auction process and the so-called wisdom of crowds. But many are the result of explicit calculation, research, judgment and the effort put in by only a few of us. If a magazine such as Consumer Reports does a good job reviewing air conditioners and its influence is felt in the marketplace, vast numbers of purchasers of air conditioners benefit.
In fact, to continue with Bernstein’s rather extreme analogy, the economic failure of communism can be attributed, to a great extent, to its utter lack of price signals. (The gutting of incentives has to be up there too -- and these are of course related, since good incentives need good prices.) The authors of the Bernstein note seem to get this, since it’s the presumed lack of these signals from enough active stock picking that they're lamenting. But what they don’t highlight is that not everyone, or not every dollar in the case of investing, has to be working toward setting prices. Indeed, it’s the natural case that many, likely most, investors don’t work toward it at all. We can all still argue about the right amount of indexing versus active management , but we should also all step back and acknowledge that free riding off of prices you rely on is essential to capitalism. Widespread availability of market prices for everything from industrial commodities to manicures is what allows independent agents to make free economic choices that lead to far more liberty and prosperity than central planners could ever deliver.
Contrast this with the service equity investors provide to the economy by bearing the risk needed for stock markets to function. Although only a small subset of investors and their dollars are needed to set prices (active investing), we need exactly the total amount of investing dollars to bear equity risk. No free riders here!
That most of us and most of our dollars don’t have to pick stocks, or to price air conditioners, is a great benefit and taking advantage of it makes us honest smart capitalists, not commissars. I understand that some think we need more active management. I’d certainly agree zero would be an odd world (no, I never figured out what happens in that world as, apparently, Michelob Light wasn’t sufficient fuel to answer this one). But when someone says you need much more of something, please make sure it isn’t a barber who just told you that you needed a haircut. And if you turn down the haircut, you’re allowed to be irked if they then damn you as worse than a communist!
Market prices become more efficient when investors gather and trade on information. Active asset managers can play a positive role in this process as they implicitly allow investors to share the information costs and benefit from professional trading. Asset managers are incentivized to perform these services well through competition among themselves and from passive investing. One attempt at solving for the resulting equilibrium efficiency of securities markets and asset management is found in the research paper “Efficiently Inefficient Markets for Assets and Asset Management” by Nicolae Garleanu and Lasse Heje Pedersen.
To be fair, the actual piece is less incendiary than the title suggests or the excerpts in the Bloomberg article imply. The authors acknowledge that passive investing has been very good for investors, and that we are far below the point at which passive investing could even conceivably harm economic growth. They avoid the straw man of 100 percent passive investing but do claim their issues occur at plausible levels of passive investment (a very arguable point). Their piece includes references to empirical studies. They don't call for government actions to subsidize active management, only a reduction in efforts to discourage it. The latter is particularly interesting as the current political climate is moving the other way. The idea of financial-transactions taxes, for instance, would penalize active strategies versus market capitalization indexing and thus move us in the wrong direction, according to their logic. Here I think I’m in the same foxhole as them.
Oh, and for the record, in my opinion, it’s likely we’ve historically had too much active management at fees that were too high, delivering returns that -- net of fees -- effectively amounted to a big and unnecessary wealth transfer from investors to active managers. The move to indexing to date is likely only a partial corrective. Furthermore, it’s very confusing to add so-called factor investors to the discussion, as the Bernstein report does, as factor investing is part market capitalization weighted indexing and part systematic active investing. Thus, it’s far from clear what it’s even doing in this debate (factor investing is often extremely price and quality sensitive, not price agnostic like cap-weighted indexing -- you might love it or hate it, but it’s not just buying everything).
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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