Worse Than Marxism?

Jonathan Clements  |  December 16, 2017

IF YOU’RE WORRIED THAT INDEXING threatens the smooth functioning of the stock market, it’s helpful to spend an hour chatting over coffee with Charles Ellis—which is what I did last week when I was in New Haven, Connecticut. Ellis is one of indexing’s most eloquent advocates, including in his bestselling book Winning the Loser’s Game and in his latest tome, The Index Revolution.

Charley dismisses the idea that index funds are distorting the market—and scoffs at the idea that active management is headed for extinction.

Yet, if you listen to others, you could be forgiven for thinking otherwise. The commentary on the topic has verged on the hysterical. Last year, AllianceBernstein even put out a research paper that labeled indexing “the silent road to serfdom” and “worse than Marxism.”

The much-publicized fear: Index funds will come to dominate the market, allocating money to stocks based on their current market value—and without any thought to what shares ought to be worth based on outlook and valuations. The unspoken fear: The beat-the-market fantasy is finally dying—to the benefit of investors, but to the detriment of Wall Street bonuses.

Yet all the handwringing is hardly justified by the numbers. Even in the U.S., where indexing is all the rage, index mutual funds and exchange-traded index funds own just 12.4% of total U.S. stock market value. To be sure, institutional investors also index. But even if you include all forms of indexing, just 17.5% of global stock market value is held by index investors, calculates BlackRock, the investing powerhouse behind the exchange-traded iShares index funds.

Moreover, in terms of setting prices, what matters isn’t assets, but buying and selling—and active investors continue to trade far more than index funds. “The only way this falls apart is if the number of people playing the game goes down,” argues Ellis, who recently turned age 80.

He estimates that 60 years ago there were 5,000 investment managers worldwide trying to outperform the market. Today, he figures the number of money managers, economists and analysts picking over the global markets is probably closer to a million. “Is that number going up or down? As of now, it’s going up. It’s interesting work, it pays well and you can work well past 65. If it paid half as much, people would still want to do it.”

Indeed, while indexing has gained converts in recent decades, many folks are still convinced they can outperform the market averages. “Twenty years ago, people said indexing was communist and it was settling for average,” Ellis recalls. “They called it passive. I challenge you to find anybody who wants to be called passive.”

By contrast, he notes, “Active investing sounds like a good idea. If you called it doomed-to-failure, it would change people’s perceptions.”

Yet the vast majority of active investors are indeed doomed to fail. Logic guarantees it: Before costs, investors must collectively match the performance of the market averages. After costs, most investors will inevitably lag behind.

Sure, a few active investors succeed—but it’s become much tougher, thanks to increasing market efficiency. Ellis notes that institutional investors account for 99% of all U.S. stock trading, up from 9% six decades ago.

“Every time you want to buy a stock, you have to buy from a person who is just as well informed, just as well educated and has just as much computer power,” he points out. “To win, all you have to do is beat a competitor who has everything you have.”

Moreover, to post market-beating returns, you have to overcome costs that might run 2% of assets per year, comprised of a 1% management fee and 1% trading costs. The latter includes market impact costs. As money managers ease out of stock positions, they push down the price of stocks they’re trying to sell, while their own buying drives up the price of stocks they’re looking to accumulate.

Wall Street frames such investment costs as a percentage of assets, which makes them seem relatively modest. Ellis prefers to think of costs as a share of likely long-run U.S. stock returns, which might average 6% or 7% a year. “It’s 2% of the assets, but it’s 2/6th or 2/7th of the return,” he says.

But what if you stick with managers who have performed well over the past five or 10 years? “People try to buy the past all the time, but it can’t be done,” Ellis says. “Anybody who has done well will likely be the recipient of substantial sums of money.”

That money has two insidious effects. First, managers get paid more—and they lose some of the hunger for success that powered their earlier triumphs. Second, they get more money to manage. “You get flooded with assets, which pushes you into the more efficient part of the market”—the big, blue chip stocks in the S&P 500. Result: A money manager’s chances of outperforming the averages grow even slimmer. Indeed, among stock mutual funds that rank in their category’s top 25% over any five-year period, less than a quarter manage to stay in the top 25% over the next five years—worse than you would expect based on chance alone.

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