Disproving More Arguments Against Index Investing

Index funds have existed for more than 50 years now. But so have critics of indexing as a strategy. This has led to a number of fundamentally flawed arguments being leveled at indexing. I debunked a few of these myths in my earlier articles Disproving Arguments Against Index Investing - I : Basic Misconceptions and Disproving Arguments Against Index Investing - II : What The Data Has To Say. But a few more arguments have been leveled at indexing in the recent months. And today I am going to disprove those arguments too.

Indexing Hinders Price Discovery

This implies that if too much money were to flow into index funds, prices would no longer reflect fundamental information. This is because indexing does not focus on security analysis. But indexing has no impact on price discovery. Index funds only accept prices. They do not determine them. Price discovery would therefore remain robust.

Also price discovery does not require most or all investors to be active. Even a relatively small share of actively managed capital is enough to exploit mispricing. Active fund managers, arbitrageurs, hedge funds, and other informed traders would always do enough in this regard. This would keep the markets efficient. And as long as markets are efficient indexing would remain relevant.

Indexing Causes Long Lasting Bubbles

This is essentially a criticism of the way market indices are constructed. Market cap weighted indices are always disproportionately weighted towards certain sectors or stocks. And this can (at least in theory) cause bubbles. But index funds hold stocks in proportion of their weightages within the index. This is only reflective of the nature of indexing as a strategy. As such, it is not a flaw of indexing as a strategy.

There are two major prerequisites for the creation and existence of stock market bubbles. These are concentration of exposure and excessive speculation. Both of these are quintessential traits of active management strategies. Indexing as a strategy does not chase stocks based on market conditions or narratives. So there is no question of speculation or concentration risk.

Market bubbles have occurred in the past. And they will continue to occur in the future. But it is clear that they are not caused by indexing. Indexing also has nothing to do with how long a bubble lasts. Valuations will inevitably revert to the mean at some point. And this would correct any degree of mispricing that had been built into valuations.

All Investment Strategies Involve Active Management

This critique is born from the fact that index funds buy and sell stocks whenever the index composition changes. There is also the argument that an active manager may be able to outperform the market with a low degree of portfolio churn. This would seemingly blur the line between active and passive strategies. But the fact is that every invest strategy would involve some degree of churn. What really matters is the intent behind the churn.

Portfolio churn in an index fund is effected to bring the composition of the fund in line with the index. This aligns the index fund to it's stated objective. There is also a set frequency to the churn (usually semi annual). And it is only a select few stocks that enter and exit the index. This would help keep costs low for investors. Compare this with the case of portfolio churn in active management strategies.

Portfolio churn in active strategies is carried out at the behest of the fund manager. So in theory there is no set frequency to the churn. But in practice the churn rate is usually high. There is also no limit to the number of stocks that can be churned. This invariably heightens costs incurred by investors. Also the churn is effected with the ultimate intention of beating the market return.

The essence of passive investing is to simply capture the market return at a low cost. So any strategy that aims to beat the market can never be considered passive. There is therefore a clear line of difference between active and passive strategies. Both would therefore always remain distinct from each other.

Indexing Would Be Ineffective Once The Strategy Saturates

On a theoretical level, there is a grain of truth to this statement. At some point every strategy reaches a point of maximum popularity. At this point the strategy would be overused by investors. Because of overuse, the strategy would lose effectiveness. This is akin to with the concept of Diminishing Marginal Returns in economics.

In theory, index investing could reach a point of saturation. This implies that most or all investors in a market would employ indexing as their primary strategy. But a practical point of view would show that the truth is completely different. A scenario where most or all investors would adhere to indexing is not plausible. It is akin to expecting individuals to remain celibate for life.

There would always be a considerable number of investors who are greedy and/or foolish enough to believe that the market return can be beaten. As long as such investors exist indexing would remain effective. It is therefore virtually certain that indexing would never reach the point of saturation.

Wrapping Up

Arguments against index investing have cropped up in past. It continues to happen today and will do so in future too. But indexing is a matter of mathematical fact. And no number of arguments against index investing would be able to disprove this fact. Any and all arguments against index investing should therefore be given the treatment they deserve. They simply must not find space in our minds.