3 Reasons to Outlaw Index Investing Right Now (and One Selfish Reason Not To) in 5 Acts
Act I: “Hello I must be going.”
Last week stunned shareholders. What happened? Did we witness a software glitch, a fat finger faux pas or a Black Swan Event? Will Washington weasel its way in to bolster its political needs? Meanwhile, the average investor – both professional and retail – faces the awful reality of the return of severe downside volatility. Perhaps the reason for those famous five minutes of May 6, 2010 resides not in any singular incident, but in the casual build-up of index investing over the last several decades.
They say things come in threes. Plane crashes, celebrity deaths, Magi from the East, etc… My favorite three things are the Marx Brothers. OK, before you purists rant, I know there were really five Marx Brothers – but we’ll get to that later. For now let us examine the case against index investing in the vein of WWGD (“What Would Groucho Do?”) or, more appropriately, WWGS (“What Would Groucho Say?”). What could the 401k fiduciary learn from how a well-read Hollywood comedian, without a high school degree (apologies, Ben Stein) but with much more than common sense, approach index investing?
First, Groucho never empirically confronted the bottom-line, he always used his “rapier wit” (as he called it) to attack the ethical unpinning of his prey. He also focused on what happened right in front of the collective noses of the audience – the very thing they would least suspect. By combining the dreadfully obvious with the irreverent absurdity of moral truth, he exposed the bully for what the bully was and rescued the lovely damsel (for the waiting arms of the leading man it turns out, much to his character’s chagrin). The subtle nod of Margaret Dumont vindicated his heroic honesty, and he lived to star in another (increasingly bad after A Night at the Opera – 1933) moving picture.
What’s the “dreadfully obvious” object in front of our eyes? Just as Quincy Adams Wagstaff spoofed the “amateur” status of college football players (Horsefeathers – 1932), a resurrected Groucho would no doubt seek to expose the veneer of the Cult of the Index. To make his point, Groucho would certainly avoid the raw greed of investment theory. If the university trustees of Huxley College were to tell him academic research has shown passive investing outperforms active investing, Groucho would snap back, “What do you think me to be? A Machiavellian? Pshaw? Sounds more macadamian, which is surely nuts to most people. And if you mix chocolate with that then you’ll have cocoanuts. But why quibble over nuts?”
No, despite his many vices our dear old Professor Wagstaff held strictly to the common sense morality of economic theory (which might account for his many vices). Well the trustees might hem and they might haw (and if his jokes hit the spot, they’d “haw, haw, haw”), but no matter what they say, Groucho would be against it.
Then, with a devilish grin and a puff of smoke from his cigar, he’d begin. I wouldn’t be surprised if he started by shooting the elephant in the room (whether in his pajamas or not). This most obvious of economic fallacies will undoubtedly shock the gentle reader, so continue only if you dare. But, be forewarned, all but a few readers will have the fortitude to reach the potentially lucrative prize in the final paragraphs of this article.
Act II: “Pull over to the side of the road and let me see your brokerage license.”
Groucho would bet your life you missed the elephant in the room. And by room, he’d mean shtick. And by shtick he’d mean sound bite, talking point, advertising lure, whatever you want to call it. It’s so obvious, you’ve seen it so often, you probably can’t remember it. That is, until Groucho so bluntly reveals it.
How many times have you heard “Why go through the trouble of searching for a great portfolio manager when, chances are, you can do just as good if not better by simply investing in the index itself?” So ends the conclusion of many an academic treatise and begins the sales pitch of every index product provider (funny how things work that way). Essentially, rather than trying to pick the best stocks, index fund “managers” merely buy a weighted portfolio of all the stocks in the index (how they justify a “management” fee when they don’t pick the stocks might present a particularly juicy target for the erudite Groucho).
In the simplest terms – the kind Groucho likes best – why do work if it doesn’t get you anywhere? Just hitch your wagon to the market and ride all the way to a comfortable retirement. In economic theory, we call this:
Reason #1 to Outlaw Index Investing: The Free Rider Dilemma (a.k.a., The Chico Problem)
“How’s it work, you ask?” says Groucho, “as easy as a no-load fund prospectus! Or, for you day-laborers out there, as easy as pushing a wheelbarrow that’s not loaded. Or, for that matter, not pushing a loaded wheelbarrow. Or, even better, having someone push you while you’re loaded on a wheelbarrow!”
National defense represents the classic free rider opportunity. We all know all citizens benefit from national defense. We therefore ask all citizens to pay for national defense. But what if some citizens don’t pay? Can we prevent them from enjoying the benefits of national defense? No. Those citizens get a free ride while all the others pay the costs of national defense.
Consider this. Index investors benefit from the rise in better performing stocks without doing the analytical work to earn the reward of discovering those stocks. If you believe in efficient markets you would discount any analysts ability to discover those stocks. However, as behavioral economists list Professors Andrew Lo and Craig MacKinlay point out in their book A Non-Random Walk Down Wall Street, the markets are not truly efficient. Therefore, the “discovered” stocks would not earn their premium if individual stock analysts had not done their research and convinced active investors to buy them. The index investor thus gets a free ride on the work of active investors (or, at the very least, the work of analysts whom active investors pay).
So sit right back and find yourself a wheelbarrow someone else can push. Of course, Groucho would hop into the wheelbarrow someone else is pushing. Not that there’s anything wrong with that.
In the old days, Groucho would have immediately jumped into the index wheelbarrow, but once he realized how the blunt laws of economics show what that index wheelbarrow might cost him, he’d jump out just as quickly as he jumped in.
To uncover these blunt laws, Groucho must venture into the deliciously absurd. For this, he’d use the famous “boundary condition test.” The boundary condition test represents a sort of sensitivity analysis. Theoretical physicists use the boundary condition test to assess the credibility of any mathematical formula. Computer programmers use the boundary condition test to analyze the reliability of their programs. Pre-Columbian navigators used the boundary condition test to check the accuracy of their maps, but usually fell off the edge of the Earth which is why we really don’t know too much about Pre-Columbian navigators. (Except, when Christopher Columbus discovered the world was really round, he also found all the Pre-Columbian navigators. It turns out they all simply forgot to take a left turn at Albuquerque.)
By discovering the common sense secret of this unique parlor trick, Groucho would joyfully bludgeon the investing elite with a third Act exposing the conflict right in front of their eyes.
Act III: “I have a mind to join a club and beat you over the head with it.”
How does a boundary condition test work? To test the boundary condition, you go to one or more extreme conditions and plug those conditions into the idea you’re testing. If the idea still works under these conditions, you may have a good idea. If, on the other hand, the idea fails at the boundary condition, then it’s back to the drawing board.
A boundary condition test for index investing assumes the realization of every index product wholesaler’s dream: All investors invest solely in the index. There are no individual portfolios. There are no actively managed funds or portfolios. There are only index investments, and the happy salesmen who sell them and the happy “managers” who get a “management” fee for not managing a portfolio. Under these conditions, Groucho would immediately discover two more very good reasons to ban index investing:
Reason #2 to Outlaw Index Investing: Market efficiency becomes mute (The Harpo Problem)
If everyone owns an index, all company stocks go up when there are net buyers of the index, regardless of the company’s financial fundamentals. Likewise, all stocks in the market go down when there are net sellers of the index, again regardless of the company’s financial fundamentals. Forget market efficiency, because company information becomes irrelevant since all companies rise and fall in tandem, regardless of their economic fundamentals, marketing strategy or brilliant management. With no one is buying individual stocks, it becomes theoretically impossible for companies to realize a stock price performance premium. In fact, the only time when one company’s stock price performance will differ from any other company’s stock price performance occurs is when that company goes bankrupt and gets dropped from the index. Ouch!
Reason #3 to Outlaw Index Investing: The capital markets disappear (The Zeppo Problem)
When there is no chance for a company to deliver a stock price performance premium, investment bankers (those evil capitalists!) have no incentive to provide the capital companies thirst for to differentiate themselves. Why? Quite simply, companies cannot differentiate their stock price performance from any other company. Come to think of it, companies don’t need to do anything different (short of surviving, but who isn’t on that wheelbarrow?) as those magnificent index investors will guarantee their stock price will perform just as well as the next company, who also doesn’t need to do anything different. Which, of course, gets us back to a whole new kind of free rider problem (you can call it “The Son of Chico Problem” but I’m sure his heirs might have something to say about that – through their attorneys).
“What?” some may certainly say, “The boundary condition test can’t represent reality because we have both active funds as well as index investing.”
“Well,” Groucho could easily counter, “aren’t those university Pooh-Bahs and financial industry mavens who constantly tout the primacy of index investing really just saying to the poor down-trodden masses, ‘Hey, poor down-trodden masses, don’t be suckered into sending your hard-earned wages to those (unindicted) criminals who charge excessively high fees for wasting a lot of time researching individual companies for an actively managed fund that cannot legally promise superior returns. No! Take your money out of those heathen funds and, instead, give it to us gentle folk who will accept a more modest fee for doing nothing more than press a button that starts a machine buying and selling whatever the All Mighty Indexer tells it to buy and sell all the while our academic co-conspirators, doing what we cannot legally do, promise you’ll accrue superior returns.’ So, you see folks, these card sharks really do want everyone to invest only in the index. Speaking of card sharks, this is the sort of pitch Chico would fall for – and did! And you have A Night in Casablanca to thank for that!”
Whew! That’s a lot of words. But, believe me, if you can imagine the quick-speaking Groucho saying these lines, it’d go a lot faster. Now, Groucho had his share of hecklers and, no doubt, there’d be heckler or two (or three, remember, everything comes in threes) in this fictitious audience shouting things like:
Act IV: “Next time I see you, remind me not to talk to you”
Heckler #1: “But index products provide liquidity essential to the capital markets!”
Groucho: “Try telling that to the poor sap whose stop loss order got executed at 2:43pm on May 6, 2010. And if you don’t believe that, try explaining the market free-fall in the first quarter of 2009. And if you don’t believe that, then I’ve got a wonderful collateralized security to offer you. It’s chock full of all the yummy goodness of subprime delights and backed by the full faith and credit of Fannie Mae, Freddy Mac and the Congress of the United States. It only had one owner, a Mr. Lehman I believe. Can’t you see you and the Mrs. riding into your personal sunset with these worthless – er – it’s worth less of an effort to own these than you think…”
Heckler #2: “But academic studies show the index consistently outperforms actively managed funds.”
Groucho: “Oh, no! You’re not going to fool me with your double talk of mathematics, statistics and (not-so) Modern Portfolio Theory. No, you freeloader, you! I’d rather tell you that you weren’t listening at the beginning when I said this wasn’t a discussion of mere mortal investment theory but the higher morality of economic theory. I’d rather tell you this but I won’t. I won’t because you’re obviously not listening. I would tell you if you weren’t listening, but I’m not getting paid by the word. In fact, I’m not getting paid at all. I’ve never been so insulted in my life! ‘Fair Use’ doctrine, indeed! Why, in my day, ‘Parodies’ was something only Chico said when he went shoe shopping, as in, ‘Yeah, Mr. Shoe Salesman, I’ll a-take a pair o’dese. And dontchoo bother bagging dem. I’ll just-a put ‘em on right-a here.’”
Heckler #3: “I don’t care what you say about the marketers, we’ll always have active investing because investors are free to choose, and some will always choose – however foolishly – to invest in individual stocks.”
Groucho: “You don’t care what I say? ‘Free to choose?’ ‘Some investors?’ ‘In?’ Why, if I had a dime for every time I’ve heard someone say that, I’d have enough Mercury Heads to fly to Mercury… What… You don’t say… Oh, ‘Franklin’ Roosevelt… Well, don’t blame me. I voted for Landon… Now, where was I? Oh, yes. This whole ‘free to choose’ idea is very quaint but very old-fashioned. It’s so – how do you say? – It’s so, Founding Fathers. My good man, the times they are a changin’. Why, when’s the last time you saw a powdered wig? And how about a wooden tooth? Or a wooden nickel? Incidentally, if you bit a wooden nickel with a wooden tooth could you light a campfire? Nope, those things, like ‘free to choose,’ have gone the way of the dodo. Did you know your very own Department of Labor is on the verge of requiring you to invest only in index funds? Sure, I know it’s hard to believe. They don’t even believe it themselves! But, the best laid plans of men and mice and all, leave it to the lawyers to gum up the works and force the obvious on the dear DOL. I’d like to say we call this ‘The Gummo Problem.’ (You were trying to figure out how we’d work that one in, weren’t you? You sly devil, you.) Anyways, I’d like to say a lot of things but, alas, death is a harsh mistress. It sorta puts the kibosh on things like Sunday drives, Monday morning quarterbacking and, in general, conversation. But, why am I telling you this, you’ll find out soon enough. We all do. Except for maybe Betty White.”
Is Groucho right? Should we ban index investing for the good of the market? After all, we did ban cigarette smoking in public places for health reasons. On the face of it, economic theory – and especially the boundary condition test – presents an interesting case to rethink the legality of selling index products. Perhaps, as economic professors ponder this (and dodge banana cream pies from finance professors), the Surgeon General can attach a warning to all index investments: “Investing in Index Products does not contain carbon monoxide, does not cause lung cancer, heart disease and emphysema, and may not complicate pregnancy. The bad news is investing in Index Products may expose you to the free rider problem (and the scorn of those providing the ride), it may give you false hopes when the market goes up, it may not protect you very much when the market goes down and it may actually lead to the demise of free markets and capitalism. Not that there’s anything wrong with that.”
Despite everything we’ve just said, it might surprise you to find out the one real reason why Groucho would never ban index investing. And, if you’re one of the few who have made it this far, you may just find yourself amply rewarded.
Act V: “I Would Never Join Any Club that Would Accept Me”
Groucho – as true a capitalist as there ever was and an even greater despiser of the “big brother” aspects of government (his book Many Happy Returns: An unofficial guide to your income-tax problems might have been a best seller if not for the unlucky coincidence it was published immediately after Pearl Harbor, putting Americans in the mood to attack other governments instead of their own). It’s highly unlikely Groucho would have favored any sort of state intervention in the markets. In fact, it’s almost certain he would have connived a way to take advantage of the situation. We’ll call this:
Reason #1 to Keep Index Investing: Self-Interest (The Groucho Solution)
The Groucho Solution involves the boundary condition minus one. In this case, everyone else invests only in the index and only Groucho invests actively. “Oh joy, oh rapture,” he would say as he counts his ever growing portfolio. In fact, he might have actually said that if, in 1939, the Marx Brothers had opted for the obvious roles in The Wizard of Oz instead of the forgettable At the Circus. Of course, if that were the case, we would have never had “Lydia the Tattooed Lady,” (unless, come to think of it, Margaret Hamilton chose to add a few more colors to her green make-up).
But I digress. Why would Groucho wish the role of the sole active manager in a world of indexers? Well, isn’t it obvious? If folks really want to have the market do their investing for them, then, according to the Harpo Problem, the markets would become terribly inefficient. If, as in the boundary condition test, all investors invest only in the index, there is no one to take advantage of the arbitrage opportunities created by these inefficiencies. But, on the other hand, if we allow one person to invest actively (i.e., “boundary condition minus one”), then that one person could buy undervalued stocks as the indexers sell en masse and sell overvalued stocks as the indexers stampede to the buy-side. And that one person would stand to make a lot of money.
And who would be the first to volunteer for the role? Groucho.
But this may not necessarily become a solo performance. Arbitrage opportunities for active managers increase as more and more investor money is placed solely in the index, not individual stocks.
Index has growth tremendously since its inception in the 1970’s, in part due to the emergence of the Efficient Market Hypothesis. Now greater than a trillion dollar industry and one that includes mutual funds, ETFs as well as individual portfolios, the ever expanding market share of index investing may, ironically, ultimate provide final nail in the coffin of the Efficient Market Hypothesis. Unlike investment theory, which focuses on returns, economic theory suggests index investing, as it becomes a larger portion of market trading volume, may artificially impact stock prices and induce greater market volatility. Not, if you’re an active manager, that there’s anything wrong with that.
In the end, perhaps it’s best to recall the one piece of sound investment advice Groucho Marx really did say: “The stockholder of yesteryear is the stowaway of today.” (Monkey Business – 1931)