Could time-honored indexing strategy go bust?

The approach has been proved to work. But as it becomes more popular, could it alter the dynamics of the market altogether?

By MSN Money Partner Jun 26, 2014 2:16PM

Couple in Home Office © Radius Images, Radius Images, Getty ImagesBy Ian Salisbury, Money.com


Indexing has always been a bit of a conundrum.


When this strategy -- which calls for simply owning all the stocks in a market, rather than picking and choosing "the best" securities -- hit Wall Street in the 1970s, it was regarded as downright "un-American."


After all, why would any investor settle for the market's average returns through indexing, when they could hitch their wagon to a stock picker whose goal is always to be above-average?


Well it turns out that over the long run, the vast majority of stock pickers aren't consistently able to generate above-average returns. Part of that is because of the higher fees that stock pickers charge, which serve as a drag on performance. But another key element is the notion that markets are by and large efficient. And it's very difficult for a lone stock picker to consistently outsmart an efficiently priced market.


Today, as indexing has transformed from a niche strategy to a widely embraced one -- more than a third of the money invested in stock funds is currently pegged to a benchmark, thanks in part to the rise of exchange-traded funds -- new questions about indexing are emerging.


Namely, if a plurality of investors switch from being inquisitive analysts digging for the truth about the long-term prospects of companies and instead throw up their hands and index, won't the market become less efficient over time? Who would be left to sort the good stocks from the bad ones, so index investors don’t need to worry about it? And if that's the case, won't active managers start to gain an upper hand again?


Index investors often disparage active stock pickers for failing to "beat the market." But this criticism gives active managers short shrift. The so-called market that portfolio managers can't beat is made up of other active managers. It's not necessarily that stock pickers aren't good at what they do. It may be that the competition is so fierce that no particular active manager can consistently beat the consensus of his or her peers.


But as more and more of the world's investors turn their back on stock picking and become indexers, that competition becomes less fierce.


This isn't just an academic debate. This topic has grown sufficiently urgent that Vanguard, creator of the first retail index fund and one of the largest mutual fund companies in the world, saw fit to publish a response.


As far as theory goes, the notion that indexing's popularity could one day alter the long-standing dynamics of the stock market isn't totally crazy, notes Vanguard senior investment analyst Chris Philips. 


"It's been an interesting intellectual debate," Philips says. But he's quick to add: "I don't know if you can quantify if there is or will be a tipping point."


One thing Vanguard is adamant about is that we haven't reached such a point yet. While more than a third of mutual fund and ETF assets today are indexed, Vanguard asserts that a far smaller fraction of the overall stock market is in benchmark-tracking strategies.


While some institutions like pension funds use indexing strategies outside of mutual funds, even accounting for these holdings, Vanguard estimates only about 14 percent of money invested in the stock market is invested in index funds.


What's more, if index funds were really driving a critical mass of portfolio managers from the market, the lessened competition would mean the remaining portfolio managers should do better. That hasn't happened. Last year about 46 percent of active managers beat the market, according to Vanguard’s tally. (If you flipped a coin half would beat it in any given year.) That was up from about 30 percent in 2012, but about equal with the number that be beat the market in 1999.


This doesn't mean the phenomenon couldn't take place at some point in the future. But even if it did, presumably more would-be stock jockeys would try their hand at attempting to beat the market at that point, which would make the trick difficult again.


Vanguard's Philips is skeptical that index investing will become popular enough to make that happen, at least not for a long time. "I'd be surprised if passive gets about 50 percent market share," he says. That's because Wall Street needs to make money and index funds are too tough a way to accomplish that.


"There is always going to be the search for an edge," he says. "There just is not a lot of money in offering an index fund."


More from Money.com


40Comments
Jun 26, 2014 4:40PM
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Use indexed funds almost exclusively for my investments.   Has worked like a charm for me since...........forever.
Jun 26, 2014 7:56PM
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what an idiot,  so in short you are simply saying that unless we personally vet the company stocks, and vet every mutual funds as a private investor the market will become inefficient?  ummm i am pretty sure the entire mutual fund insustry is predicated on the exact research you are worried is disappearing.  that said if more and more money is going into the index system, the curve, ie the difference between market pickers, and the index will naturally flatten.  you show me one... just one... person that can beat the market consistently over the long haul and short term... meaning they are always above the average...   i will buy that fund.  the single biggest problem is no one has the time to vet 4500 mutual funds let alone the 4000 stocks on all the exchanges... the best solution for most is to take the average, and invest for the long haul. 
Jun 26, 2014 10:10PM
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No matter how many or how few managers there are, one half will do better than the other half.   Or they will all be average.    And that average will be the market.  

In the short run there might be a winning strategy but it follows that others will adopt that strategy and all revert to the mean once more and often the first becomes last and the last rises to first for the short run.   You will be above average if you take a bit out when the market has risen a bunch and put a bit in when it has sunk a bunch.
Jun 27, 2014 11:17AM
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Hum,,,, is anyone really looking at how transactions are done and how money is being made in the age of electronic innovation?  Seems there is something to the previous statement since P/E are at all time highs, transaction speed, creative products, tools, etc. and we are still climbing at a rate that does not match reality.  Commodities are traded differently now also. You have no risk of delivery with an ETF.
Jun 27, 2014 9:06AM
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A ton of Time Honored strategies will soon be failing.
Jun 26, 2014 2:50PM
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no. 

 

the fund managers still have their own performance goals and will continue to dump known dog stocks, and buy truly up and coming stocks. 

 

that supply & demand dynamic will continue to happen. 

Jun 26, 2014 3:36PM
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Indexing, following the herd, works very well when the herd isn't stampeding toward a cliff.
Jun 26, 2014 7:01PM
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Recently Bernie Madoff was asked what the safest way to invest was....his answer was invest in an index fund

Great wisdom from someone who knows.

Jun 27, 2014 10:11AM
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Like we said yesterday after the close, be careful this morning folks; they did not like the little come back we had yesterday afternoon so manipulators would come out from the get go doing their thing and that is exactly what they are doing....The consumer confidence data was better than last month but that is irrelevant, people move markets, not news....Be very cautious today, these scumbags will try to do what they couldn't do yesterday....That's life down here...Crooks have a big edge....More later.
Jun 27, 2014 10:54AM
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Like we said yesterday after the close.....

Tomorrow will be another day...And the Sun will rise..

You pays your monies, you takes your chances....period.  Nothing to review later, TGIF.

Jun 26, 2014 10:45PM
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...clueless financial blog imbeciles pumping out baseless spluge..go get another degree while you're camping out in grandma's basement hoping to find yourself
Jun 27, 2014 12:13AM
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by the way, just what is it that keeps drawing me back to the photo at the top of this article?  i just can't seem to put a finger on it ...
Jun 26, 2014 11:56PM
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indexing is a close second to active investing.  it works because as a stock grows in value (take google) the index must buy more shares and this perpetuates a virtuous cycle on increasing stock prices.  of course this leads to bubbles as well.

a good allocation of the top quintile (use morningstar ratings) actively managed no-load, NTF mutual funds will outperform over the long-term however.  it's a fact.

Jun 26, 2014 3:54PM
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Boy it's bad when, many of these guys don't get their Bobo* fixes...


*edited....late

Jun 27, 2014 6:36AM
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The better article would be... 
"Are Stocks on the way out? Irrelevant and useless to anyone not already in them, also a bane and brick tied to the leg of a recovery."

Outside of the current geezer to grubber greed in stocks, the world cannot afford them. They don't do anything for the economy nor do they represent any type of of good business tool. Shareholders are generally either along for the ride or corrupt. America's best chance for survival is to eliminate them and dis-incorporate. Let's see where the "talent" goes when it has to invest in itself.

Jun 26, 2014 3:57PM
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Ahhhh, some decent Market discussion and analogies...Carry on fellas...
Jun 27, 2014 1:11AM
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OMG, Active you've been "nipping" again....Right..?? Jack and Coke...?
Jun 26, 2014 4:20PM
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No need to be concerned, really.  This will continue and for most of us here that do not invest anymore.....it makes little difference what the "markets" do, period.  All is bull and that is the next few generations problem.  They have not a clue and let them do whatever it is they can do which is not much.
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