Revisiting old comments made in 1976 on index funds highlights some very interesting points
Contrary to the adage, there is something older than yesterday's news. How about a column from 25 years ago? That's what I'm looking at right now ' a clipping, sent by a friend, of something I wrote in 1976 about the potential drawbacks of index funds. Even then it was a quixotic argument, easily ignored in the dramatic rise of the 'passive' school of investing.
And yet the question still bears thinking about: don't these funds, by their refusal to favour one stock over another, subvert the basic economic purpose of the markets?
Index investors seek merely to match the performance of an index such as the Standard & Poor's 500. By dispensing with the effort and expense of research and minimising trading costs, index funds gain an edge against the average managed fund. I didn't dispute this compelling rationale then, nor do I now. Only it isn't the whole story.
Good old 1976 was a big year for landmarks, what with the US Bicentennial. It was also the year that indexing, which had attracted a following in academic circles and among pension managers, was adapted to the mutual fund format by Jack Bogle, founder of what is now the second-largest fund company, the Vanguard Group.
Today, if you count both its share classes, the Vanguard 500 Index Fund is the largest of all mutual funds, with $91.5bn in assets. That and hundreds of other index funds account for close to 10 cents of every dollar invested in stock funds. Also, the concept has been the basis for one of the latest innovations in investing, exchange-traded funds.
So what's not to like? Well, back in 1976 John Humbach of the Fordham University School of Law and economist Stephen Dresch, as described in my long-ago column, lamented that index funds go against a prime function of the markets ” steering capital to places where it can be put to the most productive use.
'For this to work,' they said, 'investors in the capital market must pick and choose intelligently among competing investment possibilities.' Index investors don't do that, they allocate their money by default according to whatever decisions are made by other investors as a group. Now consider the reasonable proposition that many of the savviest investors are likely to be attracted to indexing, leaving judgments about which company is most promising to less prudent speculators. In that case, said Humbach and Dresch, 'capital will be diverted to less promising investments, and the entire economy will therefore lose in terms of productivity.'
By the late 1990s we had a speculative boom in the markets. For a time, the very popularity of indexing helped create demand for the big stocks that dominate the S&P 500.
Then, near the peak, money poured into stocks of small companies that had never turned a profit, and a few cases never would.
Let's acknowledge that the 1990s boom owed much to real innovation ' the birth of the internet and other breakthroughs in communications and information technology. It would have happened in any event.
But wouldn't it be interesting, if such a thing could be done, to see research on how much indexing might have contributed to the extremes of the late 1990s stock market?
'Excessive indexing can lead to an inefficient market,' says Vladimir de Vassal, director of quantitative research at Glenmede Trust Co in Philadelphia, which manages $18bn. 'The equity market can only be efficient when active investors continually adjust security prices based on new information.''
This line of thinking leads to one positive conclusion. The more 'inefficiencies' arise in any market, the more moneymaking opportunities present themselves to investors willing to stake their money on their judgment.
So unless everybody becomes an indexer, there's a self-correcting mechanism in place here. The catch is, it will function only so long as stubborn holdouts remain who refuse to index their money. To put it another way, the validity of the 'efficient markets' hypothesis that underlies index funds rests on the shoulders of people who don't accept it.
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