Hougan: Index Investing Growth Won’t Help Active Managers Outperform

There is a growing meme in the investing world that the rise of indexing as a force in the market will meet a self-fulfilling doom.

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Reviewed by: Matt Hougan
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Edited by: Matt Hougan

It’s even got a cute nickname: peak indexing.

The theory—discussed, for instance, in this excellent Bloomberg interview with John Bogle recently, or in this great exchange on “peak indexing” at Abnormal Returns—goes like this: As more and more of the market is indexed, herd-buying mentality will distort market prices. This will create the perfect opportunity for active managers to pounce, finally delivering the kind of outperformance that has eluded them for the past 20 years or so.

Active managers are seizing on this in their promotional material: “As the passive segment of the market grows, we at Templeton believe that opportunity for active investors should only get better,” wrote Franklin Templeton in a piece last year.

I even got into a little Twitter discussion about it recently.

This Theory Is Wrong

Usually, when people debunk this theory, they note (as Bogle did) that the share of indexed assets is currently too small to create these distortions. That’s demonstrably true, and should, I think, end the argument.

But there’s an even more fundamental flaw than that. Let’s posit, for a moment, that the rush of assets into index-based investments did distort prices. And let’s further imagine that some plucky active manager could identify companies that are undervalued. Amazing! But unfortunately, it wouldn’t matter a lick; as the old saying goes, the market can stay irrational longer than you can stay liquid.

If we assume the rising tide of indexed assets distorted market prices, it would do so by creating a momentum effect. In a momentum-driven market, the poor, plucky manager who identified under-loved stocks and bought them would almost inevitably suffer through months and perhaps years of fighting this momentum effect, waiting for the markets to recognize his or her genius.

Unsustainable ‘Success’

They would underperform the market. And because investors punish active managers that underperform by withdrawing money, it’s highly unlikely those managers would be able to sustain their position (or their career) while the market slowly recalibrated to the “true value” of those underloved stocks. This problem already exists for active managers, and a greater-momentum-driven market would only make it worse.

If there’s a winner in the theoretical peak indexing world, it’s not active managers but private equity firms, which could take mispriced public firms private and hold them long enough for the fundamental economics to shine through.

If you ask me, we’re still miles away from peak indexing. But if you’re worried about it, think private equity and not active fund managers. Active managers are still searching for their silver bullet.

Contact Matt Hougan at [email protected].

 

Matt Hougan is CEO of Inside ETFs, a division of Informa PLC. He spearheads the world's largest ETF conferences and webinars. Hougan is a three-time member of the Barron's ETF Roundtable and co-author of the CFA Institute’s monograph, "A Comprehensive Guide to Exchange-Trade Funds."