Why index investors are suddenly coming under attack

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Index investing, the Bambi of the financial world, is suddenly back in hunters' cross-hairs.

Consider the shot fired earlier this year by Sanford C. Bernstein & Co., a respected Wall Street research firm. Analysts at Bernstein suggested in a report that indexing – or "passive" investing in financial jargon – could be the downfall of the free world.

The tone of the Bernstein polemic was nicely summed up in its grab-for-your-gun title: "The Silent Road to Serfdom: Why Passive Investment is Worse than Marxism."

The report argued that index funds mindlessly funnel money into the same handful of market benchmarks. According to Bernstein, indexing encourages stocks to move in lockstep and disrupts the thoughtful, discerning allocation of capital to the most deserving firms.

If the trend toward indexing continues, the authors warned, free people everywhere are in peril. "A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market-led capital management," they asserted.

Yes, you read that right. Apparently the fall of the Berlin Wall, the dissolution of the Soviet Union and China's grand turn to capitalism don't count for much when matched against the awesome power of the index funds in your RRSP.

It all sounds a bit comical – and desperate, too. Firms, such as Bernstein, which charge considerable fees to help actively manage money, have strong incentives to discourage people from buying low-cost index funds.

But could they also have a point? The Bernstein report is just one of a number of recent attacks on indexing.

To be sure, it's important to keep these attacks in perspective. An overwhelming majority of neutral studies continue to praise index funds for their ability to deliver better returns than active managers.

"Put bluntly, investors are more aware than ever before that they are often paying active money managers to lose money for them and that they now have the option to do something about this disservice," says Aswath Damodaran, a professor of finance at New York University.

Still, the critics do raise some genuine concerns. Let's take a look at the leading complaints.

You're flying blind!

The oldest but still most popular criticism of index funds is that they don't actually evaluate the stocks or bonds they're purchasing.

Instead, indexers load up on all the components of a benchmark, such as the S&P/TSX composite or the S&P 500, without doing a moment of research. To critics, such an apparently haphazard approach reeks of a disaster in the making.

"The proliferation of index funds drove the '90s tech bubble and ultimately [its] collapse," wrote Christopher Pavese, chief investment officer at Broyhill Asset Management in Lenoir, N.C., in a recent note to investors. "If you thought that was painful, wait until you get a glimpse of the hangover around the corner from the blind capital piling into [exchange-traded funds]."

Sounds scary, doesn't it? But like the Bernstein paper, Mr. Pavese's indictment of indexing seems a mite overdone, especially his allegations about the dot-com bubble.

In 1998, near the height of the tech mania, indexed mutual funds represented approximately 1 per cent of the money invested in the S&P 500. It's hard to see how that relatively small group of investors could have fuelled the enormous dot-com bubble.

Moreover, Mr. Pavese's indictment ignores the fact that the loudest supporters of the market's outrageous valuations during the dot-com patch weren't indexers, but celebrity stock pickers such as Merrill Lynch's Henry Blodget and newsletter publisher George Gilder. Their plunge from grace following the dot-com crash demonstrates how quickly market superstars can become market dunces.

Such falls are precisely why index investing has grown in popularity.

Index investors believe the market is fiercely competitive and tough to beat. History demonstrates it's impossible to predict which money manager will be hot at any given time.

So why pay lush fees to a manager who may or may not do better than average? Better to buy a benchmark that represents the more-or-less average return of all those smart managers before fees. A cheap index fund ensures you get whatever the market delivers at the lowest possible cost.

The proof is in the profits. Over the past five years, 71 per cent of actively managed Canadian equity funds have failed to keep up with the index. In the United States, eight out of 10 actively managed funds have lagged behind the benchmark over the past decade.

A humble indexer would have done much better than the vast majority of active investors.

But you're ruining the market …

An indexing strategy works so long as all the buying and selling by active investors keeps market prices in line with reality.

Finance professors say such a market is efficient. An efficient market doesn't have perfect foresight. However, it reflects a wide range of information. That tends to result in more accurate prices than a single investor's opinion.

So long as a market is relatively efficient, most investors are smart to buy cheap index funds, which take advantage of the reasonably accurate market prices that active investors have already established.

Yet, some people find this a deeply disturbing notion. They worry about what would happen if everyone indexed. At that point, the market would stop being efficient. If the analysts at Bernstein are right, the free world would then teeter on the precipice.

All joking aside, it is reasonable to ask whether the growth of indexing might be eroding market efficiency. But the numbers suggest it's not a concern – at least, not yet.

Index funds are growing fast but still control only about 34 per cent of the money in the U.S. stock market and a mere 10 per cent of the assets under management in Canada, according to Morningstar. A vast majority of money is still being actively invested.

If the popularity of indexing was distorting the market in any serious way, then active managers should be able to thrive by exploiting a growing number of mispriced opportunities.

There's no indication that's happening. Hedge funds, the ultimate active traders, have failed to shine as indexing has grown in popularity. In fact, the Credit Suisse hedge fund index, which tracks thousands of such funds, has badly trailed the plain-vanilla S&P 500 over the past five years.

… and destroying the economy too!

The latest salvo in the anti-indexing battle comes from people, such as Harvard law professor Einer Elhauge, who worry that passive investing is reducing the pressure on companies to compete against each other.

According to this line of thought, indexing removes the motivation to reward companies for growing their businesses.

The logic goes like this: An index fund that owns all the stocks in a sector doesn't benefit if any one of those stocks rises at the expense of its rivals. The gains on the winner's share price are offset by the declines in the losers' stocks, and the passive investor winds up no further ahead. As a result, index funds have little reason to push any management team to do better.

It's an intriguing observation, especially because economic growth has been so slow in recent years. Maybe indexing is crimping growth by reducing pressure on executives.

But how big could the effect be? Even if index funds do nothing to prod underpeforming managers, there are plenty of other activist investors, from hedge funds to private-equity firms, that could step into the fray and kick a complacent CEO to the curb.

For now, at least, it seems premature to blame slow growth on index funds. But keep your eye on this debate.

And you're doing it all wrong!

Perhaps the most telling criticism of indexing isn't about the concept, but about how it's implemented.

The first generation of indexers emphasized long-term buy-and-hold strategies that focused on broad market benchmarks, such as the S&P 500 in the United States or the S&P/TSX composite in Canada. These indexes span many sectors of the economy, from banking to mining to auto manufacturing.

Increasingly, though, index investors are jumping in and out of specific sectors through exchange-traded funds that track industries rather than the broad market. Done this way, index investing becomes a lot like active investing – usually with bad results.

"Time and again, clear statistical evidence has confirmed that the more investors trade, the more their returns fall short of the stock market return," John Bogle, developer of the original index fund, wrote in a recent essay for the Financial Times deploring the trend. He's right. Most of us would benefit from sitting tight with a few, broad index funds in our portfolio.

But traditional indexing isn't above reproach. More than a decade ago, Rob Arnott and Jason Hsu of Research Affiliates pointed out that most indexes, such as the S&P 500, suffer from a conceptual flaw because they are constructed on the basis of market capitalization – the market value of a company's shares. The higher a stock's market cap, the bigger its place in the benchmark.

The problem with that approach is that it overweights stocks that are overvalued and underweights stocks that are undervalued, creating a persistent drag on returns.

To overcome the problem, Research Affiliates has developed a set of alternative indexes that weight companies based on fundamentals such as sales, cash flow, dividends and book value. Other companies have come up with their own approaches and "smart beta," as this rules-based approach to building an index is known, is becoming increasingly popular.

Traditional indexing, though, continues to have its proponents, in large part because it's cheap and simple. But whichever side of this debate you favour, the very existence of a heated argument over the best way to index demonstrates the growing interest in passive investing.

So long as that continues, indexing will keep winning hearts despite the best shots fired by active managers.

Just ask William Bernstein, a neurologist turned financial adviser, who's a staunch believer in the power of simple portfolios composed of low-cost index funds. "These are not complicated strategies," says Dr. Bernstein, author of many books on financial history and investing. "But time and time again, they've beaten what Wall Street offers you."