Back to May 2019

Index me out

  • Asia
  • Global

Back in 2016, Bloomberg columnist Matt Levine posed a question: are index funds communist? He could have asked more simply: are they dangerous? Or simply bogus? This isn’t to deny the merits of passive investing as part of a portfolio. Note that word – part. Does passive investing and the indexing it’s based on really justify the kind of wholesale exodus from active management into passive strategies that we’ve seen with the growth of the exchange-traded fund (ETF) industry to its present US$5 trillion-plus size? I don’t believe so.

I don’t dispute the very many very accurate and trenchant criticisms that Mr. Levine and his cohorts have made against passive investing. These are developed in such intellectual detail that some at least are bound to be right. They could have all kinds of unanticipated effects on financial markets themselves, now that passive investing has reached such scale. However, I prefer to go back to a very simple maxim: you get what you pay for. With index-tracking funds, you’re getting index-level performance, that’s all. Why go to a fund at all, then? Why not just buy a basket of representative stocks for your exchange of choice and then sit back?

Fund managers’ attempts to answer that question highlight the doublethink inherent in the indexing and passive management industry. Smart beta, factor investing – call it what you will, it’s still taking a view, picking a proposition, trying to outthink the market. Else why bother? Yet that’s absolutely not passive. It’s active management that dare not speak its name. Most passive funds and ETFs allow for rebalancing. What’s that if not moving capital around between stocks according to a view?

Plus, are ETFs really so simple? Would institutional investors really be up to speed with propositions like factor investing if it weren’t for cheap and easy ETF fund options available to access them, and fund managers pushing them as key selling points? If anything, it seems like the indexing and fund management industry has gone into an orgy of inventiveness of ever more complex and arcane factor and sub-sector delineations to differentiate their passive products and ETFs. I don’t believe many institutions or retail investors can understand these any more than the algorithms of quant funds.

In the long run, no one beats the market. Fine: in the long run, we are all dead. In the shorter time horizon, I do believe that active asset managers are capable of beating the market, and earning their fees. Institutional investors who balk at paying active management fees plough money into private equity, which has far higher costs and fees because it claims market outperformance. If outperformance is that valuable for you, why not be prepared to pay for it in active public markets investment?