As index investing has gained popularity, it is also attracted its share of scorn. The latest example is an unintentionally amusing blog post called Index funds are parasites and are going to kill the market, which appeared last week on the UK site Stockopedia.
“In a way, index investing is the ultimate piggyback ride on the coattails of the active management community,” the author writes. Even if you ignore the mixed metaphor, that’s a provocative statement. He later adds: “If there were any justice index funds would pay a tax to the active management community for their service.”
I’m not even sure where to begin a rebuttal of this kind of nonsense. Perhaps we should start with the rich irony of suggesting that retail investors are victimizing “the active management community.” Many active managers are excellent stewards of their clients’ money, and they deliver good results at a reasonable cost. But they’re not Gandhi. They’re in the game to outsmart those on the other end of their trades, and to profit from the mistakes of competitors. Yes, active traders are the reason markets are largely efficient, and in that sense index investors do benefit. But this a by-product of the activity, not its intended goal. To imply that they are providing some sort of public service is absurd.
Get out of the game
In The Arithmetic of Active Management, Nobel laureate William Sharpe explains that for every invested dollar that outperforms the market, another dollar must underperform. Once you factor in costs, that zero-sum game becomes a loser’s game, where only a small number of competitors will earn outsized returns. And when you’re invited to join a game with a low probability of success, the rational decision is not to play.
Larry Swedroe uses a clever analogy to explain this point. He asks you to imagine being a basketball player who successfully makes free throws 80% of the time. Assume the best free-throw shooters are successful 90% of the time, while the average player shoots 65%. The league is holding a competition where players are invited to attempt 100 shots and receive $100 for each basket. You are given a choice to enter the contest or simply accept the average payout of all those who participate. Which do you choose?
Your percentage is significantly better than the average player, so you probably think you should enter the competition. But as Swedroe points out, it’s likely that all the below-average players will opt out. Indeed, only the very best players should choose to enter the competition, and if that happens the average score will not be 65%: it will be around 90%. So even as an 80% shooter, you are better off not playing the game and simply accepting the average payout of $9,000.
I’m more than happy to admit I’m a below-average stock picker, and I certainly have no hope of outsmarting the best active managers. So I choose not to play the game, and to simply accept market returns at low cost. This is not parasitic behaviour: index investors are not free riders. We assume the same risks as any other market participants.
When I go to bed tonight, I will say a humble prayer of thanks to the active management community for providing the public such an efficient market. But my sleep will be unburdened by guilt for riding their coattails.