More and more investors are moving to index funds, both in ETFs and mutual funds. Cable TV talking heads and personal finance bloggers tout index funds as the best choice for most investors. Odds are you have some, if not all, of your securities investments here. What exactly would happen if everyone invested in index funds? The answer is not pretty.
No Market Capitalization
Imagine a day comes when active traders cease to exist. That’s also the day when market capitalization would cease. Active traders are the people deciding which stocks are the most valuable, and which show little promise.
Now, some argue that 100 percent investment in index funds would easily show whether stocks are valued correctly. The flaw in this argument is that price discovery is an essential aspect of the market, but it’s not something that index funds engage in. Approximately 20 percent of all stocks are owned by index funds, but that leaves an overwhelming 80 percent currently actively traded. Again, it’s those active traders who are busy every business day trying to beat the market, and without them, valuing stocks is virtually impossible. The reason some people may think 100 percent index fund investing would allow correct valuation is based on a hypothesis that has never happened and is unlikely to ever occur.
The market is all about the numbers, so let’s run some on active managers. Mathematically, active managers will always fall behind the market, on average. That’s because the total portfolios of all investors and managers must equal the market’s entire value. Keep in mind that index funds reflecting the total market own every stock, albeit in the percentage for each fund’s market cap. If there were no index funds, the entire market would prove actively managed.
Why does the average active manager fall behind the market? The key word is active, while index fund managers are passive. Before trading costs and other fees are added in, the return for the actively managed dollar will equal the return for the passively managed dollar. The active manager, however, is paying those costs, which lessens the return, while the passive manager is not on the hook for most of those fees.
Also, a passive manager of an index fund holds every security in that particular index. In contrast, an active manager will have a different portfolio, at least some of the time. Active managers conduct a lot of trades – otherwise, they aren’t active. However, the number of active managers regularly beating the market is close to nonexistent.
The Active Manager Dropout
One theory regarding a switch to index funds on the part of well, everyone, is that active managers would leave the industry. Of course, that is probably true, and the result could mean that only mediocre passive managers would remain, harming the market’s overall performance. Not many professionals would stay to perform the kind of work inherent to market efficiency, such as the necessary fundamental analysis on each security. Investors, even passive ones, would essentially fly blind when it came to the true value of a security, and mispricing would boom.
That means index fund investors would own shares of stock that are wildly overvalued. Adequate valuation of securities would prove virtually impossible. The result is not just a lethargic market, but capital not flowing into promising investments. Indeed, capital would head toward bad investments on an equal level with good investments.
On the other hand, the managers who drop out these days are generally the poor performers. That makes the market more efficient, as those remaining are better at their jobs and doing quality research.
Should the day arrive when everybody indexes, expect to see less competition among companies. Just as mergers of companies in particular industries means there is less competition, the same holds true if index fund managers feel little incentive to put pressure on a company for value maximization. After all, shouldn’t every company in the index have a shot?
Of course, that is unlikely to happen, as long as individual companies still have shareholders. Company managers are already under pressure for shareholder value maximization. These managers receive part of their compensation in company stock, making them prime shareholders, and their bonuses, salaries and very jobs depend on shareholder return. This has nothing to do with their industry as a whole, as the index fund manager scenario would have it.
What index fund managers do concentrate on today is not pressuring company managers per se, but looking at how boards are structured, that good risk management policies are in place, and overall governance and executive experience. They are not trying to tell companies how to run their businesses or change their strategic focus. Index fund managers have interests in all sorts of industries, and what may help one industry could harm another.
Beating the Market
There are investors, who look for a solid product or service and hope it will grow and increase their capital, and there are gamblers. Gambling isn’t confined to the casino, racetrack or football pool. Many active traders are inherent gamblers, not investors. You can’t argue that day traders, for example, who basically make bets based on minor price fluctuations, are investors in any sense of the term. They do their own research and have their own methodologies, but the goal is beating the market, and beating it fast.
Human nature being what it is, there will always be those for whom the market is a game, and they want to win. Most of them aren’t going to beat the market with any consistency, but they do make up a fairly large percentage of traders. The odds of these traders going into index funds for the long-term is probably lower than regularly making a killing in the market. That’s a major reason “everyone” is not going into index funds anytime soon.
The Tipping Point
Is there a tipping point at which the market would no longer function because too many investors chose index funds over active trading? As noted, only about 20 percent of the market is currently owned by index funds. Some economists theorize that index funds would have to account for approximately 90 percent of the market before such a tipping point is reached. That is obviously not going to happen any time soon, so don’t lose sleep over it.