Passively managed assets have grown dramatically since the inception of indexing in the 1970s. (Exhibit 1 illustrates this for the S&P 500® , arguably the most widely tracked index in the world.) Unsurprisingly, some active managers, as well as other critics, have raised questions about the impact of the growth of indexing. The charges leveled at index funds include suggestions that they encourage collusive behavior, that they are poor stewards of their customers’ assets, that they contribute to market bubbles, and that they diminish market efficiency. We offer rebuttals to each of these concerns, and suggest how an eventual equilibrium between active and passive assets under management might arise.
O TEMPORA! O MORES!
Recent years have witnessed a plethora of criticism directed at passive management by the advocates of a more traditional, active approach. To appreciate the extent of these claims, consider the following simple exercise. We performed a Google News search for “danger of passive investing” and found 171,000 news items. A search for “danger of passive smoking” yielded 29,700 news items.1 Yet does any reasonable person believe that index funds are more dangerous than cigarette smoke (which might, after all, actually kill you)?
Passive investing has attracted so much criticism in part because its critics sometimes conflate issues that all market participants face with issues uniquely attributable to index funds. For example, the authors recently heard an active manager describe what he characterized as flaws in executive compensation and stock option plans, which supposedly operate to the detriment of investors.2 These were described as “the hidden cost of passive investing.” His argument may or may not be correct (we are skeptical), but if it is, it describes a problem for all market participants, not just for investors in index funds.
Nonetheless, a number of respectable sources have also directed criticisms at passive management. We’ll address the following assertions:
We’ll conclude with some thoughts about how an ultimate equilibrium between active and passive investors might evolve.