The laziest investing argument in the world gets blown up (SPX, SPY)

From Money Game: ETFs
May 2, 2016 - 2:59pm

One of the hottest and laziest ideas in the investing world right now is that more money flowing into passive-investment strategies will ruin the market. We recently highlighted commentary from CLSA's Chris Wood, for example, who said that if more investors pile into passively managed, low-cost index funds, then "the index becomes the market resulting in the equivalent of investor socialism." The basic argument is that money flowing into funds that passively seek the market return creates less price discovery and leads to more potential dislocations in markets. Wood added that "The result of [this flow into passive funds] would obviously be disastrous." But would it? Actually, no, it doesn't seem like it. In fact, the increase in passive management would likely increase market efficiency. In an epic blog post published on Sunday, pseudonymous finance blogger Jesse Livermore destroys this idea by breaking down just what it means to be a passive investor and an active investor, and how people so widely misunderstand what it means to earn the market return. The first thing Livermore sets straight is that when someone is passively investing, they are doing so within a defined world of securities. In a sense, then, passively investing is an active decision, at least on the level of answering the question "What should I do with my money?" So if I call myself a "passive investor" who owns "US stocks," I most likely own an index fund that tracks the S&P 500. This means I buy a fund that owns a proportional amount of each stock in the S&P 500 relative to that stock's weighting in the index. With this investment, I am indifferent to the price of Apple, Delta, Ford, or Verizon and care that I own only a number of these shares, which reflects their relative weight in the index itself. Given that the S&P 500 is market-cap weighted, I'll end up owning more Apple than I would Delta, Ford, or Verizon, but also own more Verizon than Delta or Ford and so on. What's most important to keep in mind here is that I am not passively investing in "stocks," but in stocks that are in the S&P 500 — or any index of stocks I choose to passively invest in — in the same proportion with which these stocks are weighted in that index. The upshots here are multiple. Extending passive ownership of all possible assets is simply not worth discussing: You'd have to own a proportional share, for example, of commercial and residential real estate in every country in the world, among other practically impossible — though theoretically possible — ownership combinations. And so while a massive 34\% of the large cap US equity ownership is through passive funds, fully two-thirds of this market is still being actively managed! Let's then explore these fears about "market socialism" a bit more fully. If we take an example of a sizable index of securities — call it "US stocks," by which we mean the S&P 500 — being held in an entirely passive manner, we now obviously see that there are many other areas in which investors can actively manage their capital. More importantly, however, assuming our index of US stocks is being held in a purely passive fashion, it would take just one outside bid for a single member of this set of securities to render the index once again active. Again, passive management involves simply maintaining a proportional ownership of each of an index's securities. Price discovery, or simply bidding for one share of Facebook at the market price, is inherently not a feature of passive management because this style of investing requires proportional ownership of a stock regardless of its price. Once price or even value becomes the main concern, active management has begun. Though perhaps the biggest and most controversial implication out of Livermore's analysis is that the increase in passive management makes markets more efficient. The simple outline here is that if you allow unsophisticated investors to achieve the market return passively and efficiently — you can get the S&P 500 return for a fee of just 0.05\% per year from Vanguard, for example — you make the average remaining active manager more sophisticated. And with less sophisticated investors getting out of making decisions about their investments, the argument that follows is that the remaining investor is, on average, better. This would then lead us to expect that the average dislocat

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