Indexing Dangerous?

AS INDEX FUNDS garner ever more assets, proponents of active management have all but given up claiming that there are reliable strategies for beating the stock market averages. Instead, they’ve sought to persuade folks that they should avoid index funds, because indexing is bad for the smooth functioning of the stock market.

In essence, investors are being told, “We know that, on average, indexing beats active management. But you should still trade stocks and buy actively managed funds, because we need folks like you to ensure we have liquid markets without major mispricings.” The goal of investing is to make money, so this seems like a bizarre argument. But is it in any way justified?

It’s hard to know precisely how much of U.S. and foreign stock market value is in passively managed strategies that simply seek to replicate the performance of a market index like the S&P 500 or the Russell 2000. But we know indexing is far more popular in the U.S. than elsewhere—and yet, even in the U.S., the most generous estimates suggest that less than half of the stock market’s total value is held by index mutual funds, exchange-traded index funds and other passive strategies.

Moreover, if the goal is to ensure there’s a liquid, efficient market where investors can readily buy and sell, what’s important isn’t how much money is actively managed, but rather how active that money is. On that score, there seems little reason to worry. Stock trading in the U.S. is as vigorous as ever, despite the flood of money into index funds. In fact, according to World Bank figures, the annual value of U.S. stock trading was $23 trillion in 2019, up almost tenfold over the past three decades. How much more buying and selling do we need to have a well-functioning market?

If there are no signs that the U.S. stock market is about to grind to a halt from lack of trading, why all the handwringing over the growth of indexing? As always on Wall Street, you need to follow the money. Just as the Street has a financial incentive to belittle the intelligence of small investors, it also makes far more money from active money management than from index funds. What if the Street can persuade investors to stick with active management? Those investors will, on average, be worse off—but Wall Street’s bottom line will be fatter.

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