Monday, February 23, 2015

Index Funds: A False God?

The case against active asset management, particularly of equity investments, has many prominent expositors. Warren Buffett, perhaps the greatest known exponent of active management, made the startling remark in 2014 that he wanted his 90% of his estate to be put into a low-cost S&P 500 index fund. A more comprehensive argument is proffered in Swedroe and Berkin's excellent "The Incredible Shrinking Alpha", which is a highly readable summary of the case against active management. Swedroe and Berkin (henceforth S&B) lay out a variety of arguments against active management, which I summarize as follows:

1) Many alpha-generating factors (such as value, small size, momentum and quality) have been identified, so they can now be harnessed more cheaply, and are effectively beta.

2) In a competitive financial environment, successful trading strategies self-destruct. If a clear anomaly is discovered, investors will seek to exploit it, eventually leading to its disappearance. Or to put it more poetically, Lee and Verbrugge write, "The efficient market theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world." 

3) Alpha is a zero-sum game, meaning some investors must exploit the mistakes of others. This is becoming harder as (a) the growth of index funds drives down their costs, increasing their advantage over active funds, and creating a virtuous circle of size, lower fees and better performance; (b) the number of funds has grown, creating far more competition for alpha; (c) the "paradox of skill" means that today's active investors are better trained and have greater resources, making it harder to achieve outlier results; and (d) successful active management creates large inflows, making it difficult to replicate success.

Before proceeding, I must draw a distinction (as S&B do) between passive index funds and passive funds with systematic rules. To simplify matters, I'll refer to these as index funds and systematic funds respectively. 

I'm extremely sympathetic to argument (1). Despite my background as an active investor, I'm quite willing to accept that passive funds with systematic rules can help investors in their search process and mitigate cognitive biases. But I'm far more cautious about index funds, which ironically are seen as simpler for the average investor to understand. 

S&B themselves acknowledge the debt index funds owe to active managers: "Active managers play an important societal role - their actions determine security prices, which in turn determine how capital is allocated. And it is the competition for information that keeps markets highly efficient both in terms of information and capital allocation. Passive investors are "free riders." They receive all the benefits from the role that active managers play in making the financial markets efficient without having to pay their costs. In other words, while the prudent strategy is to be a passive investor, we don't want everyone to draw that conclusion." Essentially, index funds are derivatives of the skill of active managers and steadfastness of systematic funds. But derivatives, the ever quotable Buffett reminded us, are "financial weapons of mass destruction". The history of financial innovation seems to be strewn with examples of legitimate new tools taken to excessive lengths. We may one day think of the well-intentioned index fund in a similar fashion. 

To explain this, I turn to Argument (2), which is broadly true, but occasionally wildly wrong. While markets are generally efficient in the medium term, it doesn't take much financial history to know that sharp periods of deviation from efficiency can occur. S&B appeal to the idea that markets are better information processors than individuals due to the aggregation of collective wisdom. Likening a skilled individual investor to tennis great Roger Federer, they write, "While the competition for Federer is other individual players, the competition for investment managers is the entire market. It would be as if each time Federer stepped on the court, he faced an opponent with Roddick's serve, Murray's backhand, Gonzalez's forehand, Nadal's baseline game, Stepanek's net game and Ferrer's speed." This is a good analogy with one problem: for all its supposed skill, we know that the market occasionally has the temperament of John McEnroe or Marat Safin. While we can agree on general market efficiency, we should not over-sell the principle. Indeed, we need active and systematic funds to act as "stabilizing speculators", to quote Milton Friedman.

This can be seen simply as a rebuttal of the neoclassical EMH model. A timely new paper by the IMF's Brad Jones summarizes current arguments for deviations from the EMH: 

In similar fashion, we can raise some criticisms of index funds.

- Limits to learning: "Markets are particularly vulnerable to bubbles where there is a low level of financial literacy among participants, and common knowledge over the existence of a bubble is absent." (Jones) If investors are plowing money unthinkingly into index funds, they will have no anchor against market turbulence. This is a version of the Standing Ovation Problem, where agents act due to their own beliefs, but also out of mimicry and conformity. S&B make the following argument about active strategies: "When a strategy becomes popular, not only will it have low expected returns due to crowding, but the assets in it are now "weak hands" - the investors who tend to panic at the first sign of trouble. That leads to the worst returns occurring at the worst times, when the correlations of all risky assets move toward one." There is no reason this would not apply to index funds. 

- Frictional limits to arbitrage: "Another source of friction capable of amplifying bubbles stems from the 'captive buying' of securities in momentum-biased market capitalization-weighted financial benchmarks...Importantly, the captive buying phenomena [sic] is unlikely to abate given the (passive) benchmark-tracking exchange traded product industry has expanded at a decade-long annual growth rate of more than 20 percent (to US$2.5 trillion), a much faster rate than for other relatively non-benchmark constrained investors."

- Institutional limits to arbitrage: As index funds become ever more entrenched in the financial mainstream, it may become increasingly difficult for managers to veer from benchmarks despite valuation concerns.

To be clear, I'm not saying that index funds are unambiguously bad or dangerous. Index funds allow investors to gain exposure to equity risk at a low cost. Like any other tool, however, they should be used with care, with a clear understanding of what they represent - an investor's claims on cash flows to an underlying equity piece. S&B have done a wonderful job in bringing together various strands of the case against active management. But investors should be wary of substituting one false god for another.

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