INVESTORS HAVE BEEN following the advice in this book, pulling hundreds of billions of dollars out of actively-managed investment funds and placing them in index funds. Index funds now account for more than 40 percent of the total invested in mutual funds and ETFs. According to MorningStar, the Vanguard Total Stock Market Index Fund had over $1.3 trillion in assets at the start of 2022 and now accounts for 10 percent of all investment-fund assets. So active managers responded with a new criticism. It is now alleged that index funds pose a grave danger both to the stock market and to the general economy.
One of the most respected research houses on Wall Street, Sanford C. Bernstein, published a 47-page report with the provocative title, The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism. The report argued that a capitalist market system in which investors invest passively in index funds is even worse than a centrally planned economy, where government directs all capital investment. Indexing is alleged to cause money to pour into a set of investments independent of considerations such as profitability and growth opportunities. It is active managers who ensure that new information is properly reflected in stock prices. Indexing is also accused of producing a concentration of ownership not seen since the days of the Rockefeller Trust.
Could it be possible that if everyone invested only in index funds, indexing could grow in the future to such a size that stocks could become massively mispriced? If everybody indexed, who would ensure that stock prices reflect all the information available about the prospects for different companies? Who would trade from stock to stock to ensure that the market was efficient? The paradox of index investing is that the stock market needs some active traders who analyze and act on new information so that stocks are efficiently priced and sufficiently liquid for investors to be able to buy and sell. Active traders play a positive role in determining security prices and how capital is allocated.
This is the main logical pillar on which the efficient-market theory rests. If the spread of news is unimpeded, prices will react quickly so that they reflect all that is known. The paradox is that the very activity of active investors makes it highly unlikely that unexploited opportunities for abnormal profits can continue to exist.
I have recounted the story of the finance professor and his students who spotted a $100 bill lying on the street. “If it was really a $100 bill,” the professor reasoned out loud, “someone would have already picked it up.” Fortunately, the students were skeptical, not only of Wall Street professionals but also of learned professors, and so they picked up the money.
Clearly, there is considerable logic to the finance professor’s position. In markets where intelligent people are searching for value, it is unlikely that people will perpetually leave $100 bills around ready for the taking. But history tells us that unexploited opportunities do exist from time to time, as do periods of speculative excess pricing. We know of Dutchmen paying astronomical prices for tulip bulbs, of Englishmen splurging on the most improbable bubbles, and of modern institutional fund managers who convinced themselves that some Internet stocks were so unlike any other that any price was reasonable. And when investors were overcome with pessimism, real fundamental investment opportunities such as closed-end funds were passed by. Yet eventually, excessive valuations were corrected and investors did snatch up the bargain closed-end funds. Perhaps the finance professor’s advice should have been, “You had better pick up that $100 bill quickly because if it’s really there, someone else will surely take it.”
Active managers are incentivized to perform this function by charging substantial management fees. They will continue to market their services with the claim that they have above-average insights that enable them to beat the market even though, unlike in Garrison Keillor’s mythical Lake Wobegon, they cannot all achieve above-average market returns. And even if the proportion of active managers shrinks to as little as 10 or 5 percent of the total, there would still be more than enough of them to make prices reflect information. We have far too much active management today, not too little.
But as a thought experiment, suppose everybody did index and individual stocks did not reflect new information? Suppose a drug company develops a new cancer drug that promises to double the company’s sales and earnings, but the price of its shares does not increase to reflect the news. In our capitalist system it is inconceivable that some trader or hedge fund would not emerge to bid up the price of the stock and profit from the mispricing. In a free-market system we can expect that advantageous arbitrage opportunities are exploited by profit-seeking market participants no matter how many investors index. The facts indicate that the percentage of active managers outperformed by the index has increased over time. If anything, the stock market is becoming more efficient—not less so—despite the growth of indexing.
To be sure, index investors are free riders. They do receive the benefits that result from active trading without bearing the costs. But free riding on price signals provided by others is hardly a flaw of the capitalist system; it is an essential feature of that system. In a free-market economy we all benefit from relying on a set of market prices that are determined by others.
It is true that as indexing continues to grow, there may well be a growing concentration of ownership among the index-providers, and they will have increased influence in proxy voting. They must use their votes to ensure that companies act in the best interests of shareholders. In my own experience as a longtime director of Vanguard Group—the pioneers and leaders of the index fund revolution, with over $7.5 trillion under management—there was never an instance where a vote was made that would encourage anticompetitive behavior. I know of no examples where index funds have used their votes to collude in an attempt to cartelize any industry.
There is simply no evidence that anticompetitive practices have actually been encouraged by giants such as BlackRock, Vanguard, and State Street because of their common ownership of all the major companies in an industry. Nor would it be in their interest to do so. The same investment companies control a sizable portion of the common stock of every major company in the market. Perhaps banding together to encourage the airline companies to raise their prices would benefit their holdings of airline stocks. But this would mean higher costs for all the other companies in their portfolio that depend on the airlines to facilitate business travel. Index funds have no incentive to favor one industry over another. Indeed, since index funds have encouraged managements to adopt compensation systems based on relative rather than absolute performance, they have explicitly promoted vigorous competition among the firms in every industry.
Index funds have been of enormous benefit for individual investors. Competition has driven the cost of broad-based index funds essentially to zero. Individuals can now save for retirement far more efficiently than before. Indexing has transformed the investing experience of millions of investors. It has helped them save for retirement and meet their other investment goals by providing efficient instruments that can be used to build diversified portfolios. It is my hope that this book will encourage even further growth in the use of index funds. They represent an unambiguous benefit for society.