Friday, 2 September 2011

What Would Happen If Everyone Did Passive Indexing?

There is much advice out there telling us investors to buy passive market-cap weighted index funds (e.g. iShares' TSX Composite XIC for Canada and Vanguard's Total Market VTI for the USA) instead of actively-managed funds which try to beat the market, and instead of trying to pick winning stocks ourselves. Suppose everyone woke up one morning and "went 100% passive" so that no one held anything other than one of these ETFs or something equivalent? What would happen?

From then on, there would be no change in price of any stock as everyone, through the fund, simply accepted the last going price. There would not even be any reason to have different bid-ask prices. There would be no change in price in a day, a year, or ten years ... no matter what happened to any of the companies whose stock was in the portfolio. Now that would be interesting, we/ the fund could happily be paying big bucks for the stock of shrunken companies, or tiny amounts relatively speaking for vastly expanded others. The investor would receive no capital gains, only dividends, increasing from some successful companies and declining or disappearing from the unsuccessful ones. Things would get very out of whack.

The only change within index funds would come as a result of Standard & Poors or other index providers adding or dropping stocks from indices. It would be rather difficult for the index providers to decide which to include or exclude since the basic method relies on the market capitalization of stocks, a number which would never (or almost never, excepting new stock issuance) change in a totally passive world.

That situation wouldn't be at all stable given the reality that a) stock prices should reflect the value of the profits being generated by the components of the index, b) cagey investors would notice the too-high or too-low craziness of prices and start taking advantage by buying up strong companies with extremely high dividends. Prices would change. Active investors are thus the very mechanism that keeps prices more or less fair. Without the active investors constantly making judgements and moving prices up or down, the passive index investor wouldn't be buying a good product. Nobel Laureate Professor William Sharpe notes this ironic relationship between active and passive investing at the end of his easy-to-read article recommending Index Investing.

Why Stewardship is Proving Elusive for Institutional Investors
from the Harvard Law School Forum on Corporate Governance and Financial Regulation notes a further likely effect:
  • passive index funds exhibit poor ownership behaviour, effectively letting company management and boards run amok, as the focus on fund cost minimization leaves little money for company oversight and active involvement as a shareholder; in fact, many funds do not even have the shares to be able to vote as they lend them out to generate extra revenue and thus do not have them in hand to vote.
  • passive index funds, which own the whole market of perhaps thousands of stocks, cannot practically exercise any corporate owner stewardship even if they attempt it.
In these circumstances, it is a sure thing that abuse, rip-offs and exploitation by insiders at companies at the expense of passive shareholders, would increase considerably.

Scott Vincent in the April 2011 paper published on SSRN called Is Portfolio Theory Harming Your Portfolio? argues that the rising trend to passive index investing is increasing the opportunities for informed investors to take advantage of market inefficiencies. First, he notes that such informed skilled active investors are not new: " ... In reality, there is an abundance of evidence that markets are less than perfectly efficient, yet most practitioners and academics find that exploiting these inefficiencies is, at minimum, very difficult. It is not easy to consistently outperform the market, but talented managers can and empirical data supports this fact... " He also maintains that most studies of actively managed funds get their measurements wrong because a majority of these supposedly active funds are essentially passive. Instead of holding a few stocks, they are quite diversified in fact and therefore mostly track the index, whether consciously or unconsciously.

Furthermore, he says, "Multiple studies indicate that funds which are more actively managed, or more concentrated, outperform indexes and do so with persistence (Kacperczyk, Sialm and Zheng (2005), Cohen, Polk, Silli (2010), Bakks, Busse, and Greene (2006), Wermers (2003), and Brands, Brown, Gallagher (2003), Cremers and Petajisto (2007))".

According to Vincent, the end result of the contemporary trend to passivity is that: "... as more money flows from truly active managers to investment vehicles that deploy money “blindly,” inefficiencies become more prevalent creating opportunities for those whose eyes are open to them."

Vincent's recommendation is that individual investors can take advantage by a) searching out mis-priced securities themselves, or by b) searching out and investing their money with those truly active and truly successful fund managers - " ... look for concentrated, fundamentally-driven, relatively small funds with talented managers. Since persistence has been demonstrated in this subset, it turns out that a good manager may be identified from past performance".


Anonymous said...

I don't believe it is correct that the prices of the stock would not change if everyone invested in an ETF, as supply and demand for stocks would still change. Instead the prices of the stocks within the index would be highly correlated with one another, correct?

CanadianInvestor said...

Anon, this situation is an artificial impractical one to illustrate the extreme - 100% of people would only passively (pay the going price i.e. no price setters present) buy or sell the ETF. No one would buy/sell individual stocks.

Rob Bennett said...

I don't agree that there would never be a change in the price.

I think the price would increase each year by 6.5 percent real, the average long-term return on U.S. stocks (I am giving U.S. numbers because that is what I know).

The thing that would be stable is not the price but the valuation level. It would take a price gain of 6.5 percent per year for the P/E10 level to remain stable.

The return paid to shareholders is compensation for them giving up the use of their money. Since the business enterprises making use of the money generate sufficient profits to support an annual gain of 6.5 percent per year, that is what would be paid.

You would have to have people buying individual stocks for the individual stocks to be priced properly. In all invested in index funds, the relative values of the various companies would be messed up.

Thought-provoking post.


Canadian Couch Potato said...

Interesting post. This idea has been around for a while, but it seems to be little more than a thought experiment.

As more and more people begin investing passively, I would agree that there will be more opportunities for skilled active investors to exploit market inefficiencies. But if these opportunities come up frequently, then more and more people would abandon passive investing and become active themselves, which would quickly make the market more efficient. Somewhere along the line, there would be an equilibrium. I don't know where that point might be—maybe 30% of invested dollars invested passively? Who knows.

But if retail investors think they can reliably spot market inefficiencies today because ETFs are more popular than they were five years ago, I suggest that they're fooling themselves.

CanadianInvestor said...

CCP, I believe that market inefficiency isn't an all-or-none situation. The rise of indexing, especially that based on market cap weighting, gradually raises inefficiency. The biggest effect would be in areas where the giant ETFs are found - S&P 500, TSX 60.

As for retail investors, I wouldn't paint them all with the same brush. Those who are newbie investors, without the time, inclination and skill (financial statement literacy, basic discounting) are the ones who would be fooling themselves. But the frequent posters of the Financial Webring I daresay would eat quite a few lunches of the professional mutual fund manager and big bank full service broker investment advisor.

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