I am a great believer in index funds. I don’t think anyone has ever accused me of being anything else.
But I am often accused of being someone who has contributed to a supposed and deleterious side-effect from the growth of indexing: namely, a detrimental ‘loss’ in price discovery that presumably comes from a reduction in active management.
This claim is hogwash.
If you want to understand the theoretical basis for what would set the ‘right’ mix of active management and indexing, the great paper in the field was written by Sandy Grossman and Joe Stiglitz in 1980 (titled “On the Impossibility of Informationally Efficient Markets”). In a nutshell, they posited the “Grossman-Stiglitz Paradox”: if 100% of money was managed actively, someone could make a profit by introducing (low cost) index funds which don’t need to pay for research – but get the benefit of the price discovery done by the active managers. If, on the other hand, 100% of the market was index funds, someone could make money being an active manager since there would be no price discovery going on. The truth, obviously, must lie somewhere in the middle. (Spoiler alert: the answer is that it would occur when the total alpha from all active management was equal to the total costs of that active management, because that would be an equilibrium.)
But where is that balance? And have we overshot the mark with indexing? The answer is no. Indexing is still small enough that this is not a problem.
So why do people even ask the question? It comes down to confusion about how we price things, as economists say, at the margin.
This is best seen by thinking about a single stock. Let’s take Apple. Apple is a very liquid stock; on a typical day it trades about 30 million shares or more. That provides lots of opportunities for efficient price discovery.
But Apple has about 5 billion shares outstanding. So, at the margin, we rely on fewer than 1% of the shares trading to assess the value of all 100% of the shares.
Now, not everyone would agree on the value of Apple. But remember this – those who own the stock can sell it instantly. Since they haven’t done that, we can deduce that the owners must believe it is worth at least as much as the current price. They may disagree on exactly how much more it is worth: some might sell if it went up 1% (because they think it would then be overvalued), and others might believe it is worth twice as much as today’s price.
And don’t forget this either: at the same time many investors must believe it is worth less than today’s price (otherwise they would buy shares if they don’t already own any).
But it doesn’t matter what all those individual beliefs are. Apple’s value is determined by the aggregate wisdom of the crowd, in a giant daily tug-of-war between buyers and sellers, which is set by the less than 1% of shares that trade on a given day. The result of that roughly $5 to $10 billion of trades is the best estimate of the actual value based on the beliefs of all possible investors.
So let’s come back to the question of indexing. Suppose 2% of stocks (including Apple) were held by index funds. This means 98% would be in the hands of active investors. This also means we would rely on those 98% of investors to trade the 1% (or less) of daily shares that provides price discovery. The ratio is 98:1, which is a lot of room to allow the market to clear based on fundamental beliefs.
But even if 50% were in index funds, that ratio would only decline to 50:1. Put another way, that 1% or so that changes hands on a given day would still be a tiny fraction of what active managers hold; there is still more than enough room for efficient price discovery.
Price discovery comes from what is traded, not what is held. Even at 50%, active managers would still have huge amounts of capital that can provide that price discovery, at levels of trading we have always relied on, without a significant change.
Opinions expressed are current opinions as of the date appearing in this material only. While the data contained herein has been prepared from information that the author believes to be reliable, the author does not warrant the accuracy or completeness of such information. This communication is for informational purposes only. This is not intended as nor is it an offer, or solicitation of any offer to buy or sell any security, investment or product.