The rise of index investing since the late 1970s has been a huge benefit to investors and the markets alike. It has democratised access to virtually every asset class, market segment and investment strategy, improving the ability for individuals and institutions to actively diversify portfolios and express market views – conveniently, with greater transparency and at exceedingly low cost.
As with the introduction of any transformative technology, including exchange traded funds, or ETFs, the dramatic growth of index funds has generated skepticism among some and outright hostility from others. Some detractors have gone so far as to compare passive investing (unfavorably) to Marxism, and as a hindrance to efficient capital allocation and securities pricing.
Even the most vocal critics admit that index strategies have become positive building blocks for how investors build modern portfolios, offering all investors low cost access to diversified portfolios. At the same time, some misunderstand the impact of index funds and the role they play in capital markets. The most common misconceptions involve index funds’ size relative to the overall market, their role in investors’ asset allocation decisions, the process of price discovery, and the high correlation we see in today’s markets.
First, the basics: despite index funds’ popularity – and the panicked claims some have made suggesting they now dominate global markets – the scale of index investing is still small. While critics prefer to throw around the biggest number possible – 40% of US mutual fund assets under management are indexed – indexed investing measured broadly represents less than 20% of all global equities. And index funds and ETFs account for just over 12% of US and 7% of global equities. Ultimately, there is plenty of room for everyone.
Also lost in the debate is the critical role in driving investment flows of those who actually own the assets – as opposed to those hired to manage the assets. The decision to allocate funds to various market sectors is made by the asset owner, based on her risk tolerance, investment goals, and assessment of market factors. Should I invest in developed or emerging markets? In small-cap or large-cap stocks? The implementation choice follows the asset allocation one: Should I invest directly in stocks and bonds, or via a mutual fund? Should I buy a futures contract or a basket of securities? In a world without index funds, investors would – and historically did – make these same decisions. Index funds can be a cheaper and more efficient way to access markets, but let’s not forget they are simply one method of asset allocation. Broad asset allocation decisions are what drive flows into different asset classes, sectors and geographies. The investment style (index or active) and choice of vehicle (stock, derivative or mutual fund) are secondary decisions that don’t impact valuations.
Additionally, the whole notion of indexing has evolved. “Active versus passive” suggests a binary choice when the reality is that investors use a continuum of investment styles, from straightforward funds that simply replicate an index like the S&P 500, to smart beta ETFs that isolate specific factors like value or momentum stocks, to highly diversified active mutual funds, to concentrated active mutual funds to hedge funds that eschew a benchmark altogether. So, in a practical sense, the whole debate is based on an overly simplistic view of modern investing.
Some have said that index funds have an outsized and detrimental influence on price discovery. In fact, the price discovery process is dominated by active stock selectors. We estimate that for every $1 of US equity trades driven by index strategies, there are $22 of trades driven by a variety of active strategies. The difference reflects both the relative size of these funds and the vastly lower turnover of index strategies.
Finally, some commentators suggest that the growth of index investing is causing greater correlation among stock returns, making it more difficult for active strategies to outperform. While we agree that higher correlations complicate the opportunity for active stock selection, the primary driver of this phenomenon is global monetary policies. Central banks have orchestrated low (and even negative) interest rates to encourage investment in the real economy. One of the side effects of these policies is increased correlations of stock movements.
Are index funds and ETFs disruptive? Yes, in the sense that any new technology shakes up the status quo. But there’s a difference between disruptions to the asset management industry and disruptions to the functioning of capital markets. Price discovery and asset allocation mechanisms continue to take place efficiently and continuously. There’s no question, however, that the industry is being reshaped. Thanks to index strategies, every investor can build a diversified portfolio at low cost – something that once only sophisticated institutional investors could do – and they’ve embraced that opportunity. That’s a change we should welcome.
Barbara Novick is co-founder and vice-chairman of BlackRock