The Irony of Index funds

Recently I've been watching an interesting finance Youtuber by the name of Ben Felix, who strongly advocates for the use of diversified index funds as a primary mode of investment.

There seems to be a great deal of controversy regarding active investing vs. passive investing and the efficacy of stock picking overall. Even among big names such as Warren Buffett and Ray Dalio, there is no concrete consensus.

According to Felix, the statistical data seems to suggest that, by and large, broad market indexes outperform actively managed funds on average in virtually all instances in the long-term. Short-term high levels of performance in relation to the market by individual funds such as ARK are not totally reflective of their risk-adjusted returns, as a few good years can be easily chalked up to luck, and does not necessarily indicate consistent high performance over the long-term. (10 years straight of 30% growth is not that great if it's followed by 2 years of 55% drops)

Here's what I find interesting about this, and I'm curious about what WSO thinks. Within this is a fundamental assumption that the markets are inherently more efficient than an actively managed portfolio over a large span of time. However, the only reason markets are efficient is because there are traders and managers who actively seek to generate alpha by capitalizing on market arbitrage opportunities and incorporating market information into their trading.

Based on this, it's pretty clear that if everyone simply invested in index funds, the markets would be pretty damn inefficient, but if everyone ran with actively managed portfolios or attempted to generate alpha, there would be massive pointless overcorrection and net loss for a greater amount of people.

In this way, it seems like markets require both forms of investment, but naturally, over time, arrive at a sort of equilibrium point at which the number of active investors reaches a saturation point, after which additional active investment yields diminishing results. An analogue to this would be the economics concept of a competitive market - new companies will continue to enter an industry up until the point where economic profits in the industry approach 0.

This concept is fleshed out in the Grossman-Stiglitz paradox, to which a corollary is that:

"investors who purchase index funds or ETFs are benefitting at the expense of investors who pay for the services of financial advisors, either directly or indirectly through the purchase of actively managed funds."

Basically, your average 401k or casual passive investor can get away with returns that exceed those of actively-managed funds on average, but only by freeriding on the legwork that traders and actively-managed funds perform in the first place.

Thoughts?

Comments (34)

2y 
RK2323, what's your opinion? Comment below:

Everyone has different investment goals and timelines that could lead them to pick an active strategy. Also one of the biggest detriments to active performance compared to index is the fees. Fees can be a huge drag.

2y 
Pheer, what's your opinion? Comment below:

I guess I'm making a distinction between passive investing with a shifting focus on risk tolerance over time e.g. target date funds for retirement that just shift their stock/bond index exposure, vs. actively picking individual stocks to add to a portfolio.

2y 
Monty Burns, what's your opinion? Comment below:

While I agree that the average investor would be better off putting their money in an index, if an overwhelming amount of people did it we would see markets change for the worse, kinda like how if only algos traded with each other there would basically never be a market because there are no inefficiencies. We need the active managers, whether they make money or lose money, because they provide a sort of "chaos" that makes it so the broad market will never be fully "automated".

2y 
Pheer, what's your opinion? Comment below:

This is pretty much what I said in the OP. The point is that the market can literally only efficiently support a certain equilibrium level of active traders and investors before every additional trader would start seeing diminishing returns vs. just passively riding the wave.

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2y 
Grimloge, what's your opinion? Comment below:

Think at least for HNW individuals the appeal of hedge funds is the fact that they hedge their investments allowing for these individuals to access their money when the markets are down (i.e. March this past year) and won't be down as much. Granted very case-by-case basis but definitely one of the more appealing factors of actively managed funds  

  • Senior VP in HF - Other
2y 

Yes. There is a clearly a breaking point where the piggy backing fails. For the average person indexes make sense. Active should mostly be for large LPs. But if there is too much fee compression and active dies I think it could be bad. I think it would be akin to a fish stock collapse, once you hit a certain level a gradual decline just implodes. Its just a complete shift that would kill it - a certain level of AUM is needed to operate an active business and once that threshold is passed firms shut in. A healthy balance is ideal for the markets. 

2y 
GuyLafleur, what's your opinion? Comment below:

Yes, that's correct. Indexing works so far as someone is engaging in active trading and creating a price discovery mechanism. There's an equilibrium point and the pendulum will always swing back and forth. If too many people index, there's price inefficiencies for active traders to exploit. If too many people are actively trading, there's less arbitrage to be done and more aggregate loss to investors (taxes, fees), so people will swing to indexing to piggyback off the work of the active traders.

  • 4
1y 
jarstar1, what's your opinion? Comment below:

I tend to agree but I have a hypothetical rattling around in my head that I haven't been able to solve. Say indexing takes over and 100% of the markets are controlled by index funds, how would an active investor take advantage of that? Wouldn't traditional long-short strategies or other ways of taking advantage of growth differentials become irrelevant. Any marginal dollar added to the market would be buying the same basket of securities, adding pressure for each stock equally. Where is the pressure for one stock to go up (or down) more than another coming from, and thereby presenting an active investing opportunity? If GDP grows at a steady rate and working people are contributing to their indexed retirement/brokerage funds at a greater rate than people retiring are selling, I don't see how the stock market would do anything but inexorably advance if the entire market was indexed. 

I am almost certainly missing something, I'm just not sure what. Curious what @Pheer thinks about this as well. 

1y 
Pheer, what's your opinion? Comment below:

This is an interesting hypothetical for sure, but I think this is almost akin to borderline central planning. If everyone indexed, it seems like every single public firm would just have their share prices increase proportionally based on market cap for every additional broad etf purchased, rather than share prices changing based on individual firm performance/expectations. It would essentially be a massive pooled "US economy index" where you're basically buying into the continued growth of the US economy rather than individual firms. Shorting or selling would be akin saying "I think the entire US equity market is overvalued"

I think this is only useful though as a thought experiment because if you view the markets from a sort of Darwinian standpoint, eventually with news/reports about individual firms' performance people will opt to sell indexes that have heavy exposure to a particular overvalued company, and people will eventually just resort to active trading again to cull shares of companies they deem to be overvalued and buy more of those that are perceived to be undervalued.

A key point of this is that all value is subjective, so a share price at any given point is basically the intersection of all investors' subjective valuation of a particular firm's worth. In the long-run this generally tends to oscillate around its book value/fair value as far as I'm aware.

I think it can be compared to that phenomenon where if you ask any individual how much a cow weighs, they tend to be quite off, but the average of a large sample set of answers tends to be close to the true number.

Part of what makes the public markets so powerful and efficient is that companies' valuations are always changing based on their performance and public sentiment. In the absence of active trading, with everyone just using market-wide indexes, there would be no real way of "rewarding" companies who are outperforming and "punishing" companies that are lagging because the price discovery mechanism would just disappear. Rather than every company having to prove its worth, the public market essentially just becomes one massive group insurance policy.

2y 
Snort the VIX, what's your opinion? Comment below:

I disagree with the premise that all actively managed funds contribute to market efficiency. Maybe all the active funds that are consistently underperforming dont actually do that. By definition only funds that outperform actually successfully find inefficiencies to exploit. So outperformance of index funds is not at the expense of firms making the market more efficient because those that actually make the market more efficient still beat it. 

If you consistently make bad investment decisions then chances are, you are making the market more inefficient. So to that extent, your contributions to price discovery are worse than those of index funds.

  • 2
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2y 
Angus Macgyver, what's your opinion? Comment below:

Obviously not ALL actively managed funds make good decisions. The ones that don't will see their capital diminish over time, and will shut down as people withdraw.

Also the fewer actives out there, the easier it is to find clear inefficiencies to exploit (because there are fewer people looking for them). So it's easier to be a "good" active when there are few actives in the market, and the number of actives goes up over time, until all the juice from the inefficiencies are squeezed out, then the number of actives goes down again. It's a naturally self-balancing equilibrium.

2y 
financeabc, what's your opinion? Comment below:

Well, most of the data indicates that passively managed funds outperform active funds and these studies do not even account for taxes/survivorship bias.  When you add these factors to the analysis the argument for passive investing is even stronger.  This topic is not new nor is the data.  I think the more interesting topic here is why do active funds underperform benchmarks when they hire some of the smartest people in the world.   You would think that these people have the skill which would lead to better results.  Now, the hedge fund and private equity world would probably say that they get better results but good luck finding the data to support this conclusion.  

  • 5
2y 
Pheer, what's your opinion? Comment below:

I guess this is the key distinction between large scale data and individual performance. Anyone will tell you that the odds of becoming an NFL player are slim to none, but the fact is that somebody is going to get there regardless of the odds. If more people listened to the odds and chose not to pursue that track on account of its low probability, it'd become a lot easier for those that do try - so it's only difficult insofar as lots of people are trying to do it, which makes it harder.

PE funds I would argue are a bit different because they have actual operational leverage and control over their portcos vs. just the speculative capital allocation that hedge funds engage in.

  • 2
2y 
Pierogi Equities, what's your opinion? Comment below:

Howard Marks of Oaktree had a very good memo in the past year when he posited this, would recommend reading it.

Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.

  • Analyst 1 in IB - Cov
2y 

Which one? I know he's put out a lot in the past year 

  • Research Associate in AM - Other
2y 

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2y 
Sequoia, what's your opinion? Comment below:

Your premise is incorrect. All actively managed funds do not underperform on a long term horizon. Most do, which is a very different thing. In U.S. funds only 15% outperform their indices on a 10-15yr time horizon. When you blow that out to global given the much bigger opportunity set & wider divergence in company quality, that comes out to ~20%.

Given high underperformance of active, it would be correct to say that the bottom 80% will gradually bleed into passive / alternative investments. However, if entire market was passive there would be way too many companies that are too cheap / expensive....which would naturally draw active managers to close those inefficiencies  

  • 2
2y 
Pheer, what's your opinion? Comment below:

Not sure if you read my whole post but this doesn't contradict what I said really at all.

  • 1
2y 
ke18sb, what's your opinion? Comment below:

I'm of the opinion that all of these passive/active discussions are to broad and need to be bucketed into individual investors vs large LPs. For the average individual investor the argument/data is very strong to only invest in passive funds. Once large LPs are incorporated there should be an entirely different conversation. Setting aside of all the largest LPs just went passive it would likely breakdown the systems, there are a bunch of qualitative reasons they hire fund managers on an individual basis and from a portfolio perspective. From the portfolio perspective, these aren't binary decisions. Active managers are part of a broader portfolio of investments that try to maximize total return through cycle. So maybe they have a lot of money in just index tracking funds, then some in a variety of HF strategies, funds that target specific sectors, etc. Also, many large LPs want control of sorts through SMAs - maybe they have certain parameters they want to invest in / not invest in. There can be varying degrees of risk tolerance in a managed portfolio that is dictated to the LPs. They also want the touch of being able to talk to portfolio managers. To a degree, active managed funds are there for when you least expect it like periods of covid. 

2y 
Fill-or-kill, what's your opinion? Comment below:

IMO indexing is more complicated than people think. Most strategies are devised to shrink indices further or to gain exposure to something broader indices can't access. Those strategies see capital flows. Redundant strategies see capital exits (and fee compression). Active managers mostly start with an index and shrink it down to factors they want to isolate and participate in. However, the majority of active managers today are still redundant (do we really need another large cap fund?). 

2y 
Lester Freamon, what's your opinion? Comment below:

This is a good thought and I agree with your conclusion that there has to be both passive and active investors for passive investing to work for the reasons people have mentioned. What I will also add as a primarily passive investor, however, is that I'm not concerned about there ever not being "enough" active investors in the markets. I think the whole $GME and other meme stock rally very recently is a good example of how outsized gains tempt people too much and there will also be enough people who outperform for a solid period (say 5 to 10 years) that will tout how it is in fact possible to consistently beat the markets.

There's a lot of good literature about how being a good investor comes mostly down to psychology/temperament and less so about smarts.   For example, the people who tend to do well neither get carried away by their victories or overly despondent about their mistakes or missed opportunities. We're all human and at least partially slaves to our emotions. As long as there aren't AI robots trading the markets while us humans sit around all day collecting UBI, I think there will always be certain inefficiencies in the market from people getting overly greedy or fearful for the active folks to try and capture and outperform the passive folks. 

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2y 
redever, what's your opinion? Comment below:

I've seen this rise as a "youtube" debate also, interesting to watch but some major points get missed...

1. As passive index investing has risen in share, returns to active managed funds and hedge funds generally (this is really too broad to generalize in fairness) have not improved in any consistent (sure, winners and losers right?). In "theory" the ability to generate alpha would increase but it hasn't seemed to happen. This really doesn't prove much, but it strikes in favor of passive investing (at least for now).

2. Information is cheaper/easier than ever to get - This is what I see the "YouTubers" missing so much! If you wanted to "follow" stocks back in the 80s or earlier, you looked at shit ton of paper research and maybe even did calcs on a HP-12c. With computing power today and open/cheap streams of data (including word search indexing "crawlers"), practically anyone can run a "prop shop" from their basement. Algo trading is cheaper and cheaper and even the big brokerages have opened this capability up to retail investors. Why is this important? It means that their are probably more "Active" traders than ever. Add this with cheaper transaction costs, easier margin deals, and more liquid option markets... and bam, hard to say active isn't more active than ever. This alone probably counts for the degradation of alpha at some many mutual and hedge funds, hell of a lot harder to have a "unique idea" these days and even more probability your trading action gets discovered and copied by others. Again, a point for passive! 

3. There are always "active" traders - This one pisses me off the most... Some "YouTuber" makes it sound like if all investors go passive (will never happen) stocks could somehow go to zero on any volatility. This is total bullshit, publicly traded firms have boards, officers, employees, customers, suppliers and others who "know" them. If some weird wave "Crashes" the value, ALL those people will buy like crazy! No company with going concern value is going to zero or even close to, there are always insiders and near insiders, and their trades matter. Hence, the "big fall" idea will generate tons of "actives", thus the theory is dumb. Score for passive.

There are some knocks against passive to be clear...

1. Similar stocks trade lock-step - This happens with REITs and other clusters of firms that trade in sector ETFs/mutual funds, they all move together even when they clearly shouldn't (happened at lot at times in 2020). This does "reverse" itself with time, but arguably it shows some clear inefficiency. Still, not sure how well an "Active' can fight the trend. That is scary, but still actives can win (but may need to be more concentrated).

2. Index funds can move the market - This seems clear and is a bit scary, relates to the above point but more macro. Due to the expansion of options and ease of trading of options, as well as general liquidity of index ETFs, trading "Action" in these instruments can move the market, including crash it. Ironically, this is "Active" trading activity but only possible due to the vast sums of "passive" liquidity from investors not really seeking to trade but for personal liquidity reasons. This makes them somewhat riskier in theory. Of course, "active" manage funds would have to be able to protect or improve upon the returns of the index to justify their fees (hence create alpha by lower volatility and downside protection). Not much proof this is happening, but it is plausible. Still, how much extra fee do you pay for this service? 

3. Stock "plays" may actually be huge value centers - This story came home big time last week with the reddit run on GME and other "meme" stocks. Better story with Tesla, but the idea is the same. You may actually want to have "exposure" to some of these "popular" stocks. The issue is that if you own index funds, you already do! The over concentration of tech stocks is huge, hence the problem..... index investment may not really diversify you very well. For 2020, this was "good" and probably led to overperformance, but also was a feedback loop (like the point above). Thus, index investing does feel like "active" investing without the fees (the ultimate freeride!), but it is as much on the back of random retail investors (i.e. robinhood effect) and hedge funds as it is actively managed mutual funds.

So.... personally... what do I do with all this? I am largely fully invested in index funds. They are in my 401K account at Vanguard (literally the default option, but changed my allocation), my personal account, my IRA, pretty much all places I can use them. I do some individual stocks, but I don't make active trading a thing. I don't have the time to "manage" stocks in my portfolio, and I low confidence in mutual fund "managers", so I go with low cost diversification! Still, I do wonder about all this often. 

Great thread!!!! 

1mo 
pihyper, what's your opinion? Comment below:

redever

I've seen this rise as a "youtube" debate also, interesting to watch but some major points get missed...

1. As passive index investing has risen in share, returns to active managed funds and hedge funds generally (this is really too broad to generalize in fairness) have not improved in any consistent (sure, winners and losers right?). In "theory" the ability to generate alpha would increase but it hasn't seemed to happen. This really doesn't prove much, but it strikes in favor of passive investing (at least for now).

2. Information is cheaper/easier than ever to get - This is what I see the "YouTubers" missing so much! If you wanted to "follow" stocks back in the 80s or earlier, you looked at shit ton of paper research and maybe even did calcs on a HP-12c. With computing power today and open/cheap streams of data (including word search indexing "crawlers"), practically anyone can run a "prop shop" from their basement. Algo trading is cheaper and cheaper and even the big brokerages have opened this capability up to retail investors. Why is this important? It means that their are probably more "Active" traders than ever. Add this with cheaper transaction costs, easier margin deals, and more liquid option markets... and bam, hard to say active isn't more active than ever. This alone probably counts for the degradation of alpha at some many mutual and hedge funds, hell of a lot harder to have a "unique idea" these days and even more probability your trading action gets discovered and copied by others. Again, a point for passive! 

1. Where did u get the data for this? Not saying I don't believe you, but would love to dig into the data here. From a first principles perspective, this doesn't make sense, since the increase in general market inefficiency due to the rise of passive has to be benefitting someone...

2. I wonder what percentage of these part-time basement Robinhood traders are actually conducting fundamental research and assisting in price discovery, vs what percentage are just following the hype (whether consciously or subconsciously) and putting money in generic blue chip stocks. There are probably even a decent proportion that are just meme stock traders aping into GME AMC. Ultimately, if you look at the "retail active" category and filter for those who actually help make the market more efficient (as opposed to those who just march with market, whether consciously or subconsciously), are there really enough to move the needle?

1mo 
redever, what's your opinion? Comment below:

So my thoughts/opinions....

1. There has been tons of research on active vs. passive/index investing, and conclusions have remained consistent (just google it, lots of papers published on the matter). I just found a very recent New York Times article about how this has remained the case through 2022 and actual worse when compared to 2014 https://www.nytimes.com/2022/12/02/business/stock-market-index-funds.html. Also, I would personally refute the notion that there has been an "increase in general market inefficiency", in fact, my general point is that markets are far more efficient due to increased ease and speed of data and ability to process. Econ/finance theory (don't ask me to quote the papers, but I know they exist, read back in grad school) show you don't need everyone to be "informed" (the academics term...) traders for the market to be efficient, just enough to trade actively to move the market to allow for price discovery. Thus, the rise of more hedge funds, active retail/HWI traders, and insiders (easier for them to trade also...), can easily overpower the rising share of index vs. active mngt wealth. So, IMHO, the rise of passive investing has not make the made the market more inefficient, and there has been no evidence this is the case (despite the rantings of some YouTubers and financial advisors hoping to sell actively managed funds). Even the returns of hedge funds (which are generally not public, but somewhat known via proprietary research and the returns/disclosures of public funds that invest in them don't show great results when fees and leverage effects are accounted for. With 2022 a down year, this is about as good a test as any to see the benefits of 'active' management, not sure how it will shake out, but I haven't seen anything yet to suggest its a more winning year (there are always some that beat their indices, but as the NYT article stated, NONE did it consistently, that's a heavy indictment of active mngt); many do admit or claim that the benefits is 'lower lows' and volatility in down times, this year will be a great test! 

2. The question of how many are needed to "move the needle" really matters only with respect to whom else is trading at that time and with what intensity. In an individual stock, probably not much, especially if all in same direction. I suspect few retail investors (whether the Robinhood types or more HWNI types) do much fundamental research directly BUT they do follow and act on the research of others. Thus the impact of "reddit" and similar stock tip sharing services (free and paid) could be large if many traders (and I suspect many active 'sophisticated' types like HFs do as well) follow the advice (regardless of personally doing the research). This is called "herding behavior" and frankly I can recall research (peer reviewed type) that showed the same "herding" behavior in mutual fund managers. So, what does it take to "move" the heard? Is it is as simple as a reddit post/thread or a tweet? Maybe, but its not about who did the research or made the finding, but who acts on it. In today's digital world... that can be a large group as information can flow super fast and freely. You add on all the algorithms that are built to literally detect "unusual volume" and trade with it (early momentum seekers, often looking what could be a signal from an insider), and getting wild runs on individual issues seems like its easier than ever. That is literally hyper-efficient relative to waiting to read the Wall Street Journal each morning or watching CNBC to see what's discussed (like what those traders would have had to do in the 90s). So the point isn't really how many traders are "smart", it's how many are trading the signal, that is all that matters.

  • Associate 1 in IB - Gen
1y 

If I'm not mistaken, Ben Felix mentioned that even with the massive passive inflows today, only 5% of a stock's daily trading volume is from ETF/index investing. Granted there may be some quasi-passive investors and closet indexers who could make this 5% higher, but without a doubt, active investing is far more responsible for stock pricing than passive (as of right now).

I think we can all agree that active investors are the ones who are doing all the heavy lifting to make markets as efficient as they can be. Without them, there would be extremely inefficient pricing. However, the trillion dollar question is how much active investors do we actually we need to keep markets relatively efficient.

Jack Bogle of Vanguard speculated that we could still have efficient markets even if passive investing made up 90% of the trading volume - which would especially be bad news for most people in the asset management and hedge fund industry. Nobody knows where the sweet spot is but with confidence most can surmise that a starting career in active investing today may be an uphill battle.

Personally all of this info really disappoints me. I love investing and researching a company's growth catalysts and seeing how my thesis compares to consensus. I find the whole process very cerebral and it's why I started my career in sell-side equity research. My initial plan was to move to the buy-side at a HF but after watching this guy on YouTube and reading up on the amount of active fund managers who beat the market long-term, it's got me really in my bag. Why would anyone want to work at a HF when 99% don't add value? Seems like a waste of time to constantly grind only to add literally no value to anyone.

1y 
Pierogi Equities, what's your opinion? Comment below:

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Quant (ˈkwänt) n: An expert, someone who knows more and more about less and less until they know everything about nothing.

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