Morningstar Magazine - October/November 2017 - 12

Dispatches

Do Index Investors
Deserve Perdition?
"Not guilty"
on all counts.
IVORY TOWERS

John Rekenthaler

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 whom the charge of self-interest is more
difficult to make.
In order of seriousness, there are three charges:

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 ETFs. The conclusion
is grossly premature. 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.
For another, the argument would fail even if
the work were completed, because the underlying
logic is unsound. The shares of Exxon Mobil
XOM will rise if the buy orders for its shares are
more numerous and/or more impatient
than the sell orders, and vice versa. Whether these
orders come from indexers or active investors
is immaterial.
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%.

1 Index funds have inflated the stock market.

Verdict on Count One: Not guilty.

2 Index funds have distorted how equities are priced,

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

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 market indexes have
become overvalued, while the second says nothing
about overall index levels, but instead questions
the market's internal efficiency.)

1 Partoy, F. 2017. "Are Index Funds Evil?" The Atlantic, September.

12

Morningstar October/November 2017

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. While a company may be
overlooked by one, other indexes may compensate.
Also, index-fund investments are made across
hundreds or even thousands of securities. If
indexing does lead to security mispricings, those
effects have been diluted by diffusion.
While the suspicion lingers that index funds cause
some pricing disparities, the proof is difficult to
find. Over the past five years, S&P 500 funds have
attracted several hundred billion new dollars more
than have mid-cap index funds. Yet Standard &
Poor's MidCap 400 Index has gained an annualized
14.3% for the five years through August, while the
S&P 500 is close behind at 14%.
Yes, companies held by the S&P 500 have received
massive proceeds that other firms have not, but
the effects have been minor. When index funds
exit, trillions of actively managed dollars remain to
fill the gap. Consider First Solar FSLR, dropped
from the S&P 500 in March, after the company
lowered its 2017 profit forecast. The stock took a
two-month beating but recovered when First
Solar raised its estimates. The stock is now 50%
higher than when Standard & Poor's announced
the company's departure from the benchmark.
Verdict on Count Two: Not guilty.
There may come a time when indexing is so
prevalent that it meaningfully damages
the stock market's efficiency, but that time has
not yet come.
Bad Actors?

Side Effects

There's something more to the second claim, that
index funds affect how stocks are priced
within the marketplace. Every U.S. stock index
makes judgment calls. There are always companies
that could have been included, but which
were left out because they were on the other side
of the line the index provider draws. That line

In "Are Index Funds Evil?,"1 The Atlantic outlines
a criticism that has been around since forever
(1984), but has evolved recently: Index funds
encourage bad corporate behavior. The current
charge is that 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.



Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2017

Contents
Morningstar Magazine - October/November 2017 - Cover1
Morningstar Magazine - October/November 2017 - Cover2
Morningstar Magazine - October/November 2017 - 1
Morningstar Magazine - October/November 2017 - 2
Morningstar Magazine - October/November 2017 - Contents
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