Is Index Investing Good For Our Society And Economy In The Long-Run?
I work for a firm that recommends index investing for a portion and often a majority of client portfolios. It’s hard to form an argument against it. Broad diversification and low fees with the majority of active managers underperforming their index fund counterparts in recent years. I’ve always accepted the general consensus that using index funds make sense. I still do… for now.
My question: Is a society made up entirely of index investors a good thing?
The United States has had the strongest economy in the world for decades. Most economists would cite easy access to capital for our businesses as a major contributor to our nation’s economic success. On the flip side, lack of capital is the #1 cause for business failure. So I think it’s safe to conclude that the easier it is for businesses to raise funds via stock and bond offerings, the greater the chance of their success.
U.S. public companies are required to release reliable financial information about their operations on a quarterly basis with external audits done annually. This information is what allows investors to make informed decisions as to where to put their money. The high standards for reliability build confidence in our system as a whole and for this reason, money from around the world pours into our borders to invest in our companies’ stocks and bonds. This gives us a clear economic advantage.
As a result of frequent and transparent communication of financial results, companies with the strongest balance sheets, revenue growth, expanding margins, etc. garner the most investor capital. Companies with dismal balance sheets, dwindling revenue, and low liquidity don’t raise as much cash.
In the early years of the stock market, mom & pop investors had difficulty affording quality research with which to make informed investments in individual companies. Then came the mutual fund. All of a sudden, regular people could pool their money together to make it cost-effective to hire research teams (i.e. portfolio managers and analysts) originally reserved for the ultra-rich. The middle class now had an economically viable method for identifying attractively valued companies. These research teams would comb through the financial reports of hundreds of companies to build a “fund” they felt contained quality businesses worthy of their investors’ capital. In my opinion, this was a MAJOR step in the right direction for our economy. The middle class could finally participate in the growth of our nation’s best companies.
In today’s market, we now have index funds which compete against actively managed mutual funds for client dollars. An index fund is a group of securities batched together with no direct weight placed on the quality of the companies in the group (and hence no research). Rather, the weight assigned to each company in the fund is based off of differences in market capitalization of each company. These differences in market capitalization among the companies in the index group can only exist if some investors in the marketplace ARE investing actively, not passively. The active selection of an investor choosing one company over a competitor creates value differences (i.e. market-cap differences) that drive the company weightings within our index funds. Coke or Pepsi? Mercedes or BMW? Williams-Sonoma or Restoration Hardware? The larger the market cap of a company, the heavier the weight in the index fund.
What does this tell us? An index investor is piggy-backing off of the value decisions made by the active investors in the market without paying for the research. Sounds great right? But what if our active investors who do all the work in terms of research give-in and jump on the index band wagon? What happens to our value differences among companies in any given index? What happens to our economic advantage?