Index investing is a trend on the rise. I have written multiple articles (Why I Believe in Passive Investing and Index Funds and Passive Fund Management: Understanding the Opportunity) on the many benefits of investing in index funds. As with anything that gains popularity and threatens conventional wisdom there are counter arguments as to why index investing may not be the best thing for you or the market.
I strongly recommend a recent Vanguard white paper that effectively addresses some of these claims.
Now before you read on, I know what you’re thinking: “Of course, this article will support Paul’s view of index investing, because it’s leveraging a study by Vanguard, a firm that is synonymous with the index investing movement.” However, despite Vanguard’s growth in the index investing space, it is also the world's third largest active manager with over $1.6 trillion under management. While this is roughly half of its passively managed assets, it still represents a significant portion of its business.
Here are two common arguments against index investing:
1. “Indexing artificially impacts stock pricing.”
What does that mean? If everyone buys and sells entire indexes (i.e. buying every stock and bond in the index) then, in fact, the price of each individual stock in the index will rise and fall no matter what. All of the stocks move not based on individual merit but because it is a part of the index. This, in turn, either inflates poor stocks or unfairly depresses the price of worthy stocks.
The Reality: Index trading only makes up 5% of the market. So, this argument becomes moot under the current circumstances. According to Jack Bogle, even if index trading is 80%-90% of the market the remaining actively traded portion would be adequate to efficiently price stocks.
2. “Indexing makes markets more volatile.”
What does that mean? If every investor bought and sold entire indexes, then prices would inevitably move up and down erratically and within a wider range.
The Reality: While the percentage of assets in indexed strategies has grown, market volatility has risen and fallen in a seemingly random pattern with notable spikes around the tech bubble and the great financial crisis. So, historically speaking, markets are volatile with no evidence to suggest that indexing alone could force the market to swing.
And One Undeniable Fact
The expense ratio, or cost of investing in an index fund is almost always less than the cost of investing in an actively managed account. Lower costs are a positive for investors, and a key reason why active managers don’t particularly like index funds, since it means less money in their own pockets. On page 4 of Vanguard’s report, the authors state, “According to our estimates, without index funds, investors would have paid more than $150 billion in additional investment costs cumulatively since the early 1990s […] Further, we believe that index funds have introduced competitive price pressure to the industry, at least partially explaining the downward trend in active-fund expense ratios.”
We’ve all heard the arguments against index investing. I encourage you to consider whether they are compelling enough to avoid taking a passive approach to investing. Remember, it’s very difficult to beat the market and impossible to predict the future.
As Larry Swedroe writes, “No one has found a way to identify which few active funds will manage to outperform in the future, as there is no evidence of persistence of outperformance beyond the randomly expected. Just like roulette or craps, the surest way to win a loser’s game is to not play.”
What else do you want to know about getting started with index funds? Write to me at Paul@lakeroadadvisors.com.