Wall Street has ridiculed passive investing for decades. The reason is obvious: Its profits—and for many firms, their very survival—are at stake. The criticism reached an absurd level when a team at Bernstein called passive investing “worse than Marxism.” The authors of the note wrote: “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.”
Another example of such criticism was an article titled “What They Don’t Tell You About Passive Investing.” Produced by Morgan Stanley, the thrust of the paper was that “the exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management.”
The basic argument of these and other critiques is that the popularity of indexing (and the broader category of passive investing) is distorting prices as fewer shares are traded by investors performing the act of “price discovery.” Let’s examine the validity of such claims.
Before doing so, it’s worth noting the irony that if indexing’s popularity was actually distorting prices, active managers should be cheering, not ranting against its use, as it would provide them easy pickings, allowing them to outperform. (Note that if money flowing into passive funds distorts prices, it could still make it difficult for active managers while it is occurring, as distortions could persist as long as the flow continued. Eventually, though, the opportunity would manifest itself.) In reality, the rise of indexing has coincided with a dramatic fall in the percentage of active managers outperforming on a risk-adjusted basis.
Supporting Research On Manager Skill
The study “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, which appeared in the Summer 2014 issue of The Journal of Portfolio Management, found that the percentage of skilled managers was about 20% in 1993. By 2011, it had fallen to just 1.6%. This closely matches the result of the 2010 paper “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” The authors, Eugene Fama and Kenneth French, found only managers in the 98th and 99th percentiles showed evidence of statistically significant skill. On an after-tax basis, that 2% would be even lower.
In our book, “The Incredible Shrinking Alpha,” Andrew Berkin and I present evidence, as well as the reasons, for the dramatic decrease in active investors’ outperformance on a risk-adjusted basis.
In addition to the evidence on the failure of active management to persistently generate risk-adjusted alpha, it’s easy to check whether increased flows to index funds are causing price distortions. If that were the case, all securities in an index would be rising/falling by about the same percentages, as cash is invested based purely on market capitalization.
As I pointed out in my annual look at lessons the markets teach investors, the S&P 500 Index returned 21.8% in 2017, including dividends. In terms of price-only returns, 182 of the 500 stocks were up more than 25%, 49 were up at least 50%, 10 were up at least 80.9%, and three more than doubled in value. The following table shows the 10 best returners:
On the other hand, 125 stocks within the index, on a price-only basis, were down for the year; 59 lost at least 10%, 20 were down at least 25% and the 10 largest losers (see the following table) lost at least 44.2%:
Another example that demonstrates the exaggerated claims about passive investing’s effect is the year-to-date returns of Amazon (AMZN) and General Electric (GE), both of which are in the S&P 500 Index. Through May 1, AMZN had risen 34%, while GE had fallen 18%. If passive investing were driving prices and destroying the price discovery function, we would not have seen such wide disparity in returns. Clearly, active investors engaged in price discovery are still trading, and their activity must be what is setting prices.
One final example. Every day on cable financial news networks, we observe how stock prices jump (decline) immediately after companies announce better-than-expected (worse-than-expected) earnings. Because index funds do not trade at all on earnings announcements, it must be the price discovery actions of active investors moving prices, correcting the prior prices to account for the new information. Just how quickly prices adjust is testament to the market’s efficiency.