Many things that are useful to individuals prove harmful when viewed from a society-wide perspective. Are passively managed indexed mutual funds one? A friend of the blog sent along a link to this WSJ story:
If investors continue to pile their money into passive index-tracking, at some point markets will stop doing their job of allocating resources efficiently in the economy. Perhaps they already have.
The threat is big enough that the world’s largest pension fund is preparing to put more of its money with active managers—who charge more and on average underperform—in an attempt to keep markets functioning properly. ...
Hiromichi Mizuno, chief investment officer of Japan’s $1.4 trillion Government Pension Investment Fund, worries that market efficiency will be damaged by the rise of passive funds, which rely on trading by active investors to set the price of stocks.
Obviously, passive management is the ideal way for retail investors (like you and me) to invest. Most of my retirement savings are indexed, for example.
Yet, the WSJ piece is hardly the first time global concerns have been raised about the trend towards passive investing. The New Yorker had a breathless piece back in 2016, for example.
So, are we collectively harming market efficiency? One problem is that a lot of the research on this area has been funded or conducted by people with a dog in the fight.
Personally, however, I find this analysis pretty persuasive:
But while indexing could be a problem in theory, we are not convinced that indexing poses a problem in practice, for three reasons. First, while the quantity of actively managed assets has been shrinking recently, we believe the quantity of actively managed assets provides an imperfect indication of the amount of active management. Not all active managers are the same. Some are more “active” than others. There is wide variation in investment styles across the population of active managers, from the strength of each manager’s conviction to the size of the coverage universe and the level of trading activity.
Second, a growing number of indexed portfolios reflect “active” views insofar as they pursue goals which are commonly associated with active management. Smart beta strategies that provide exposure to common equity factors are one example. These increasingly popular portfolios may be indexed, but that doesn’t mean that they are “passive” in the same way that market-weight indexing is passive.
Third, many indexed portfolios are used to implement tactical (active) views within asset allocation strategies. Active investing still occurs, but via thematic portfolios and/or at the asset-class level rather than via individual stocks.
So go on feeling good about indexing your investments.
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