Swedroe: Myth Busting Index Investing

Back in June, I noted that Wall Street has ridiculed passive investing for decades. The attacks began almost from the moment John Bogle started the First Index Investment Trust (later renamed the Vanguard 500 Index Fund) on Dec. 31, 1975.

At the time, competitors heavily derided it, even calling it “un-American” and “Bogle’s folly.” Now-retired Fidelity Investments Chairman Edward Johnson was quoted as saying he couldn’t “believe that the great mass of investors are going to be satisfied with receiving just average returns.”

One of the many ironies is that Fidelity is now one of the leading providers of index funds. It also was the first fund family to offer a zero-expense-ratio index-based ETF.

False Claims

My article went on to reveal the absurdity of certain claims made about passive investing. Yet even this type of exposure doesn’t seem to stop the perpetrators of such baseless assertions. After all, their profitability, and even their very survival, depends on investors believing that active investing is the winning strategy.

A July 2018 article on Seeking Alpha, “Passive Index Investing, A Bubble Bound To Burst?”, provides another opportunity to expose the false nature of claims made about passive investing. I’ll examine some of the assertions made by the author, beginning with: “Investors are euphoric about passive indexing, and it is becoming an overcrowded trade with low prospective returns over the next 5-10 years.”

Let’s begin by examining the claim that passive investing is becoming overcrowded. According to the Thomson Reuters Lipper second-quarter 2018 snapshot of U.S. mutual funds and exchange-traded products, active funds of all kinds, including money market funds, manage about $16.4 trillion. That’s more than 2 1/2 times the $6 trillion managed by passive funds and ETFs. If anything is overcrowded, it’s active management.

Shrinking Alpha
As explained in my book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, for decades now, academics have been busy converting what once were sources of alpha into beta through the publication of their findings.

For example, while there was a time that active managers could claim alpha by overweighting small-cap, value, momentum, quality, profitable and low-beta/low-volatility stocks, that is no longer true. The reason is investors today have access to those factors through low-cost, passively managed funds, such as index funds and ETFs.

In addition, the publication of information about anomalies, such as post-earnings announcement drift, which causes momentum in stocks with positive or negative earnings surprises, leads to their shrinkage, or even disappearance.

Yesterday’s Alpha Becomes Today’s Beta

The result is there are fewer sources of alpha. Yet according to the 2018 Investment Company Fact Book, at the end of 2017, there were more than 16,800 funds, the vast majority of which are actively managed. Compare that figure to the roughly 100 active funds there were 60 years ago. The supply of alpha is shrinking, while the number of funds trying to feed at the alpha trough has mushroomed. There just isn’t enough alpha to go around. Active management is overcrowded.

As to the author’s claim that overcrowding leaves passive investing with low prospective returns over the next five to 10 years, I refer you to William Sharpe’s “The Arithmetic of Active Management.”

In his famous paper, Sharpe noted that because the market consists of active and passive investors, and, in aggregate, passive investors earn the market return less low costs, in aggregate, active investors must earn the same market return less high costs. The result is that if passive investors are doomed to low returns over the next five to 10 years, it is due to the fact that valuations are high, not because of any overcrowding.

No Active Magic

Additionally, in aggregate, active investors also are “doomed” to those same low gross returns, but with even higher expenses.

The author continued with a discussion on the efficient markets hypothesis and claims that the superinvestors of Graham and Doddsville demonstrate the hypothesis is false.

While it is true there is a group of such investors all from the same ZIP code, and while the Buffett style of investing certainly generated alpha for a very long time, academic research has converted that alpha into beta. It uncovered factors that fully explain the excess returns of those superinvestors relative to the single-factor (market beta) CAPM, the three-factor (adding size and value) Fama-French model, or the four-factor (adding momentum) Carhart model.

Factor Access

Thus, the once-alpha for those superinvestors has now become beta when we include the newer quality and betting-against-beta factors. Many low-cost, passively managed funds provide access to these factors.

The author next discusses Andrew Lo’s adaptive markets hypothesis. Lo’s hypothesis, which I fully agree with, is that, while markets are highly efficient, they are becoming ever-more efficient as academics uncover sources of alpha and convert them to beta. Once that happens, as I’ve mentioned, passive funds can access them in much-lower-cost ways.

As good examples, the funds my firm used 20 years ago only accessed the beta, size and value factors. Today we now access the additional factors of momentum, quality/profitability, carry and what can be called defensive (such as low beta/low volatility). In addition, these funds all engage in patient, algorithmic trading strategies to minimize implementation costs.

Price Takers

The author went on to note: “The flow of trillions of dollars into passive funds (along with central bank actions) has pushed financial asset prices through the roof, via massive buying irrespective of price and fundamentals.”

This shows a complete lack of understanding. Passive investors are price takers, not price makers. The actions of active managers drive prices, not those of passive managers. If you want any more proof of that, just look at the huge dispersion of returns we see every year in the stocks in the S&P 500 Index. If passive managers were driving prices, all the stocks would move by the same percentage. The reality is far different.

As one example, in 2017, the best-performing stock in the S&P 500 Index was NRG Energy (NRG), up 132%. The worst-performing stock was Henry Schein (HSIC), down 54%. That’s a gap of 186%! It cannot be explained by anything other than the actions of active managers. I’ll take this opportunity to note that, despite this type of wide dispersion, which is normal, once again, the vast majority of active managers failed to outperform their benchmark indexes.

Consider Facebook & Twitter’s Drop

As further evidence of the absurdity of this claim, just consider the recent sharp drops experienced by Facebook (FB) and Twitter (TWTR).

This past July 25, FB closed at $217.50. After the close, FB reported weaker-than-expected results. The opening price the next day was $174.89 (a drop of about 20%), and it closed at $176.26. Index and other passive funds did virtually no trading on those days (except if a fund had to redeem shares or create new ones, and even then it would trade FB shares in proportion to its total market value in the index, and thus would not have affected FB’s relative price).

The entire change in prices relative to the market was explained by the actions of active managers, both in driving up its relative price before the announcement and in driving it down after the announcement.

Active Price Reactions

On July 26, 2018, TWTR closed at $42.94. Like Facebook, the company reported weaker-than-expected financial results. It opened the next day at $37.25 and closed at $34.12 (down about 21%). Again, the stock’s relative price action both before and following the announcement is explained totally by the actions of active, not passive, investors.

The price action of FB and TWTR show both that the market is highly efficient in processing new information and that the actions of active managers drive stock prices, not those of passive investors, as claimed by the critics.

The author also stated: “Passive index investors expecting returns similar to the S&P 500's quoted 10% annualized historical returns are in for a big letdown.”

Lower Future Expected Returns

Although I would say that it is likely they will indeed be disappointed, it is a very misleading statement as to any cause-and-effect relationship. Investors have to understand that part of the explanation for the index’s high historical return is that valuations were much lower in the past. And higher valuations forecast lower future expected returns.

Most financial economists now expect forward-looking nominal returns for U.S. stocks to be in the 6-7% range, or 4-5% in real terms (versus about 7% historically). As I noted, that has nothing to do with the trend toward passive investing and everything to do with current valuations.

Passive Diversification

The next issue I’ll address is the claim that index diversification levels are suboptimal. The author writes: “Often referred to as the only free lunch in finance, diversification is not being well-served in many passive index investment vehicles. The 30 largest companies in the S&P 500 account for almost 40% of the index's total market capitalization.”

First, there is nothing all that different today than in the past in terms of concentration. Even the author notes this: “Though this isn't actually too out of line with historical levels, it's still something to take note of.”

That said, remember that because all stocks must be owned by someone, collectively all passive investors own the market-cap weighting of each stock, as do all active investors, collectively. Thus, if the issue is one of concentration, it’s just as much a risk or concern for active investors.

Fama’s Passive Definition

Second, the author seems to be conflating passive investing with the exclusive use of total market funds.

If we instead define passive investing as no individual stock selection or any market timing (Eugene Fama’s definition), passive investors can diversify away concentration risk through allocations to small and value stocks, for example. Furthermore, they can do so by investing in passively managed small and value funds, such as the ones my firm recommends in constructing client portfolios run by AQR, Bridgeway and Dimensional Fund Advisors.

More importantly, because passive funds buy all the stocks in their eligible universe, they typically are far more diversified than active managers’ portfolios.

For example, model portfolios my firm, Buckingham Strategic Wealth, uses as starting points for discussions with clients hold at least 12,000 stocks and typically more than 20,000. That’s many multiples of the typical number of holdings for an actively managed portfolio.

Threat To Livelihoods

Proponents of active management will continue to attack passive investing. In almost every case I’ve come across, these attacks not only are without foundation, they also are absurd and easily exposed as such. But that doesn’t stop them. The reason is simple: Passive investing threatens their livelihood. Thus, their behavior should not come as a surprise.

For those investors seeking above-market returns, the answer is not to engage in active management. While it is possible to win that game, the odds of doing so are so poor that it’s simply not a prudent choice to play.

Instead, the answer is to seek greater exposure to unique, independent factors demonstrating a historical premium that has been persistent across time and economic regimes, pervasive around the globe, robust to various definitions, is implementable (meaning it survives transaction costs), and has intuitive risk- or behavioral-based explanations for why you should expect a premium going forward.

Seek those greater exposures through low-cost, well-diversified, passively managed funds.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.