Editors Note: This article was republished with permission from The BigLaw Investor.
Recently, Robert Shiller gave an interview on CNBC where he questioned the value of indexing investing and expressed particular concern should 100% of the market move to indexes. What would happen if everyone invested in index funds? Let’s explore that idea.
Robert Shiller is a Nobel-prize winning economist famous for, among other things, developing the Shiller P/E ratio (also known as CAPE) which takes the average earnings of a company over the last decade to smooth out the impact of business cycles and other events to give a better picture of a company’s sustainable earning power. He’s a smart guy that thinks Bitcoin is a bubble. But when it comes to index investing, I’ve got a few questions.
The interview (three-minute video below) raises the following questions:
- What happens if 100% of investors are invested in index funds?
- Are passive index investors getting a “free ride” on other people’s work?
- Why didn’t they talk about index investing 100 years ago?
- Has passive investing been a bad thing for the market?
- Was the strength of the country build by people who had opinions on the price of stocks?
100% Invested In Index Funds and Free Riding
If 100% of investors owned an index fund, we’d be in a pretty awful situation. Why? Because, we need the active investors to buy and sell stocks to set the price for the various securities. The index funds mostly just track the market capitalization. We can’t know the market capitalization unless an active trader is out there deciding which companies are worth more than others.
But should we fear a coming time when there are no active investors? Not if you’re familiar with the Gotrocks Family. That’s because as long as we have a stock market, we WILL have active traders trying to beat the market.
If the market becomes less efficient as more investors shift to index funds, it only increases the likelihood that some investors will shift to active investing to take advantage of the inefficiency. Plus, do you see people like Warren Buffett and Carl Icahn switching to index funds? They’ll continue doing what they do best and will be happy to pounce if a company’s valuation gets out of whack.
For that reason, I can’t see any scenario where the market becomes 100% index investors. And how many active investors do you really need to set the market prices? Not that many. We only need enough to make sure the market is setting prices efficiently. As long as we have hedge funds, pension funds and Ivy League endowments, we should be fine.
Does that mean as index investors we’re getting a free ride on the work of the active investors? Yes it does. It’s a free ride I’ll happily take. Let the big boys bash each other over the head trying to one up themselves in market. Meanwhile, I’ll capture all the intrinsic growth in the market that comes from the companies actually producing value.
Where Was Indexing 100 Years Ago?
Duh. You couldn’t do index investing before computers. Can you imagine how much work it would be to create a hand ledger tracking 4,331 public companies? And then you’d have to set up a fund that maintained the market capitalization of those companies on a daily basis? Impossible.
So the fact that investors weren’t talking about index fund investing 100 years ago is the same reason they weren’t talking about cat videos. They didn’t exist.
But doesn’t Shiller claim that the strength of the country was built off the backs of those active investors toiling in the market to create efficiency? Sure, the efficiency of the market is critical to its growth. If those traders hadn’t been moving shares back and forth setting prices along the way, we wouldn’t have a functioning market. But let’s not kid ourselves. Those traders were trying to make money, not working for free. And did they create all the value? Well, I’d argue that the vast majority of the value came from the company’s capital and it’s employees working tirelessly to bring profits to the corporation.
Finally, the interview suggest that passive investing might be a bad thing for the market. It’s certainly a bad thing for the financial advisors that think they can select winning stocks for you. It’s a bad thing for the brokerage houses that make money on every trade and thus are heavily incentivized to encourage you to make transaction. But index investing hasn’t been a bad thing for investors. And since it’s your money, would you prefer to help out the market or yourself? I don’t find it convincing that as an investor I should be more incentivized to do what’s best for the market than what’s best for me as investor.
Let’s talk about it. Are you worried that one day index investing will become so dominant that we’ll no longer have active traders? Do you find any of Schiller’s arguments compelling?
This article was republished with permission from The BigLaw Investor.