Investment Insights

Is Indexing Getting Too Popular?

Crowd on boardwalk

Market watchers have noted the stunning growth of indexed vehicles over the last few years. Coupled with the ease of trading and transparency of exchange-traded funds (ETFs), the low cost and tax efficiency of indexing have led to a boom in the growth of these vehicles to the detriment of actively-managed mutual funds. With indexing beating the majority of active managers in most asset classes, indexing has been an easy concept for investors to buy into.

Domestic equity index funds (including ETFs) have seen growth in assets every single year since 1993, with net new flows exceeding $250 billion in 2016, according to Ned Davis Research. In contrast, domestic equity active mutual funds have seen net outflows for 11 straight years beginning in 2006. Last year, net outflows topped $320 billion, the highest on record.

The popularity of indexing has been driven by a convincing performance advantage. According to the Wall Street Journal, the last time more than half of actively-managed U.S. stock funds consistently beat the S&P 500 on a rolling 12-month basis was in the middle of the last decade. Even then, the percentage of outperforming funds never reached 60 percent. Notably, these comparisons exclude the impact of taxes, which would skew the results even more in favor of indexing.

Some active managers argue that they can protect investor capital better than an index during market declines. The evidence would say otherwise. The WSJ cited a study that looked at the market crash of 1973-74, when the S&P 500 lost 37.3%. Stock funds lost 38.9% on average, even though they had almost 10% of their assets in cash at a time when interest rates exceeded 7%!

Indexers have a legitimate concern if we reach the point where indexing becomes a dominant force in equity markets. Since traditional indexing allocates money on the basis of market capitalization (i.e. company size), it is conceivable that valuations could become disconnected from company fundamentals, and that the largest companies would attain extremely high valuations based upon attracting the lion’s share of new fund flows. So far, no evidence exists to support this claim. Apple, as the largest company in the S&P 500, represents about 3.7% of the market cap of the index. It trades at a price/earnings ratio in line with the market as a whole, about 18 times earnings.

Estimates of indexed assets range from approximately 28% to 35% of total fund assets, but when including individual securities held in retail brokerage accounts, the percentage of indexed assets drops to below 15%. In other words, indexing has a long way to go before it can move prices in a material way. In the meantime, active managers will be doing their best to correct any obvious mispricings caused by indexed fund flows by shorting overvalued stocks and buying undervalued ones.

Indexing has had a long run of superior performance, and nothing lasts forever in financial markets. Indeed, 63% of active managers beat their benchmarks in April, their best month since February 2015. But one month does not a trend make. If active management in US stocks is to stage a recovery, managers will need to find a way to overcome the inherent drag of higher costs and less tax efficiency compared to their indexed brethren. It is a tall order.

Learn more about Bruce Simon, our Director of Portfolio Research.

Read more about our investment philosophy and process.

 

This report is the confidential work product of Ballentine Partners.  Unauthorized distribution of this material is strictly prohibited.

The information in this report is deemed to be reliable but has not been independently verified. Some of the conclusions in this report are intended to be generalizations.  The specific circumstances of an individual’s situation may require advice that is different from that reflected in this report.  Furthermore, the advice reflected in this report is based on our opinion, and our opinion may change as new information becomes available.

Nothing in this presentation should be construed as an offer to sell or a solicitation of an offer to buy any securities. You should read the prospectus or offering memo before making any investment.  You are solely responsible for any decision to invest in a private offering.

The investment recommendations contained in this document may not prove to be profitable, and the actual performance of any investment may not be as favorable as the expectations that are expressed in this document.  There is no guarantee that the past performance of any investment will continue in the future.

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