Don't give index funds the finger

Are passive investors worse than Marxists? These are people who buy index tracker funds to invest in a whole financial market, instead of trying to pick individual firms to invest in.

Allister Heath has an entertaining and mischievous piece today, inspired by a recent investor’s note, which toys with the idea that they might be a problem. Though he (correctly, of course) concludes that “Marxism is always worse than everything else, including of course trackers”.

But are they really a problem at all? I think not. The case against them can be summarized like this: since passive investors don’t move their money out of bad firms, and don’t raise their voices against bad executives at shareholder meetings, they misdirect capital and effectively subsidise bad firms. They follow the herd and when they do succeed, it’s because they’re free-riding on the efforts of active investors.

Worst case scenario: if they were the only kinds of investors, there would be stasis. Capital would be completely locked up in bad firms and financial markets would grind to a halt. Capitalism as we know it would be over – hence the comparison with Marxism.

But in this worst-case scenario we can see why (a) this would never happen and (b) passive funds’ supposed flaws aren’t problems at all. Indeed, as well as free-riding on active investors, passive investors subsidise them too.

Consider a world where nearly all capital – 99% – was invested by algorithmic passive index funds, and the other 1% was invested by very lazy “active” investors. In this world, a certain phone company has a market cap of £10bn – at the point at which the last genuinely active investor left the market, its future profits and assets were reckoned to be worth £10bn in current-day terms (for that is what determines a company’s share price).

But something unexpected happens to boost the firm’s future profitability – the firm developed some new technology that made its phones cheaper to build, say. In a world of active management, that would cause new, properly active investors to buy the now-undervalued shares held by the lazy “active” investors, bidding the price up until the firm’s total value reflected its newfound expected profitability, and moving capital into that firm from other firms or investments which are now relatively less profitable. Passive funds, of course, would follow suit by design.

In a world where there were zero active investors, of course, this wouldn’t happen and the firm’s price would be stuck at a too-low level. But as long as there are some people willing to enter the market when the returns are big enough, that too-low level would induce non-investors to enter the market as active investors! Get-rich-quick schemes would, here at least, really work. Buy some shares at just above the market price but below its ‘true’ value, either from a fund or from the firm directly through a new share issuance, and you’ve made potentially quite a lot of money overnight. Easy.

The reverse would work too. If the firm had lost value – maybe its phones unexpectedly became unfashionable with consumers, or its board was just managing it badly – something similar would happen as profitable short-selling drove the price down and down.

In other words, if and when passive investments became inefficient, that inefficiency would create an incentive to become an active investor.

Clearly, barring legal barriers to entry, a world of all passive investors is impossible for long. To the extent that this happens in our mixed market – with passive investors slowing down stock price movements, perhaps – the subsidy is there for active managers who spot and act on changes in firm value before the others. The more passive investors, the greater the returns for the active investors.

All this reminds me of a paradox of efficient markets. If markets were 100% efficient, there would be no money to be made in active investment. But if there was no active investment, markets wouldn’t be efficient. So the equilibrium is somewhere in-between – and just where you think that equilibrium is probably determines whether you want to invest by picking winners, or be passive and let others do that hard work.

Do passive investors free ride on active investors, or do they subsidise them? Yes.