3 Reasons Index Investors Deserve Perdition (or Not)

The Hot Seat Lex III: Actioni contrariam semper et aequalem esse reactionem: sive corporum duorum actiones in se mutuo semper esse aequales et in partes contrarias dirigi.

More colloquially, for every action there is always opposed an equal reaction—Newton's Third Law of Motion. To his misfortune, Newton knew nothing of index funds—they would have served him far better than the South Sea shares that he so disastrously purchased—but his axiom applies to their discussion.

Because what went up is very much coming down. To be sure, most financial journalists continue to recommend index funds. However, several other groups are resisting, loudly. Active portfolio managers, brokerage firms, and financial advisors, who have long criticized the practice of indexing, have intensified their complaints. They, of course, have axes to grind. But recently they have been joined by some academic researchers, against which the charge of self-interest is more difficult to make.

In order of seriousness, the criticisms sort into three categories:

1) Index funds have inflated the stock market.

2) Index funds have distorted how equities are priced, by bloating the shares of companies that are in the popular indexes, and neglecting the shares that are not.

(These two arguments might seem similar, but they are not. The first states that the Dow Jones Index has become overvalued, while the second says nothing about overall index levels, but instead questions the market's internal efficiency.)

3) Index funds harm the process of corporate governance.

Toil and Trouble The notion that index funds have created a stock-market bubble can easily be popped. (Sorry about that.) For one, this claim is customarily made by citing the inflows into indexed mutual funds and exchange-traded funds. That is but a starting point. To understand how much of total stock-market inflows comes from indexing, one would need to add the figures from the other major participants: pension funds, foreign investors, individual buyers, and the corporations themselves. The conclusion is grossly premature.

For another, the argument would fail even if the work were completed, because the underlying logic is unsound. The source of stock demand matters not. The shares of

The upshot is that U.S. fund inflows are useless for understanding stock-market behavior. In 2009 and 2010, when the S&P 500 rose an aggregate 46%, flows into U.S. stock mutual funds and stock ETFs were negative. The market was up; funds were redeeming. Four years later, in 2013 and 2014, the S&P 500 gained an aggregate 51%, but this time cash flows were strongly positive. Last year, cash left stock funds once again, and the index was up 12%.

Verdict: Not guilty. If indexers are to burn, this will not be the sin that sparks the blaze.

Side Effects There's something more to the second claim, that index funds affect how stocks are priced within the marketplace. Indeed, that argument surely must hold. Every U.S. stock index makes judgment calls. There are always companies that could have been included, but which were left out by the index provider, because that is where the provider draws the line. That line matters for attracting (or repelling) assets, particularly with the major indexes.

Once again, though, things are more complex than they seem. There are dozens of stock indexes, often overlapping, so that while a company may be overlooked by one index, other indexes may compensate by bringing it assets. Also, index-fund investments are made across hundreds or even thousands of securities, rather than targeted. If indexing does lead to security mispricings, those effects have been diluted by diffusion.

And while the suspicion lingers that index funds must have caused some pricing disparities, the proof is difficult to find. Over the past five years, Standard & Poor’s MidCap 400 Index has gained 14.3% annually, while the S&P 500 is up an almost-identical 14.4%. During that time period, S&P 500 funds have attracted several hundred billion of new dollars more than have mid-cap index funds. Where does that show in the results?

Verdict: Not guilty. There may come a time when indexing becomes so prevalent that it meaningfully damages the stock market’s efficiency, but that time has not yet come.

Bad Actors? The latest charge against indexing is that index funds fail with corporate governance. Historically, the funds were accused of neglect. Because index funds hold so many securities, passively rather than with active intent, critics wrote that index-fund managers paid little attention to proxy statements. In doing so, they abdicated their responsibilities as shareholders, thereby letting corporate managements walk over shareholders.

The allegation has since been strengthened. In "Are Index Funds Evil?"—and you thought that this column's headline was clickbait!—The Atlantic outlines a charge that has been around since forever (1984), but which only gathered attention recently. Index funds, the critics state, do something far worse than merely ignoring proxies. They encourage bad corporate behavior. Specifically, they enable collusion, which boosts the profits and thus the share prices of the companies that they own, but at a cost to overall society. Indexers hurt us all.

Tuesday’s column will address that claim. Suffice it to say that this line of attack, unlike with the previous two, comes from academia, meaning that it has the advantage of being less biased, but the disadvantage of being more obscure. Unpacking that argument will take some doing, as will assessing its validity.

Verdict: The jury is in deliberation.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.