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Average active funds have no answer to their weightless index tracking rivals

Image of astronauts floating in space

War! What’s it good for? How about reducing fees to nothing?

Yes, fund giant Fidelity is now offering North American investors a US total market equity index tracking fund and an international equity tracker fund with fees of 0%.

While many still complain the markets are rigged and that small investors get a rotten deal, Americans who do their research can now invest for free.

So is this it? Investing nirvana?

Not quite.

Firstly these funds are for US consumers – and British investors still seem to pay higher fund fees than US investors in general. That said, even we can get cheap index trackers costing 0.1% or less a year.

Cost-wise, going from there to zero isn’t as big a leap as ditching an expensive active fund charging 1% or more. The big wins have already been achieved.

More subtly, as my co-blogger The Accumulator likes to say even cheapskate passive investors know someone has to be paid somewhere. So what’s the catch?

I see two potential wrinkles.

Firstly, the new 0% funds track Fidelity’s own in-house indices, rather than indices from one of the benchmark behemoths. This will save them paying licensing fees to the likes of MSCI or FTSE, but many investors would prefer index homogeneity across the tracker fund universe.

Second, the 0% funds will probably lend shares to short-sellers for a fee, which Fidelity will pocket. Some feel this practice sees a fund’s investors taking the risk but the manager getting the reward.

Neither wrinkle would stop me investing.

All indices are constructs and I expect a company of Fidelity’s standing has put together something reasonable. (We’ll look into this in the future).

As for the stock lending, defaults on security loans in such circumstances are rare, and should be covered by collateral. The Accumulator has previously expressed concerns though, and it’s true stock lending does add counter-party and related collateral risk to what ‘should’ be a simple fund.

You’ll pay (or not!) your money and take your choice.

Heroes and zeros

One thing not to worry about is Fidelity’s bottom line. The firm achieves roughly $18bn in annual revenues. Most of that comes from managing retirement accounts, active funds, and share trading, not from trackers.

When we last did a roundup, the cheapest world equity index fund for UK retail investors was already from Fidelity, charging just 0.13%. But apparently they offer US investors an equivalent charging just a tenth of that!

Going from such low fees to zero won’t upset Fidelity’s business model anytime soon. Rather, the zero percent funds are a loss leader, like our free current bank accounts. The firm will aim to make the money up elsewhere.

It will also cause headaches for rivals such as Vanguard and Blackrock. These index fund giants are less able to go to zero without scything their revenues.

The future of active management

Eventually I think we’ll see an index fund that charges a negative fee.

That’s right – you’ll be paid to invest!

A fund would achieve this by passing on those stock lending fees to its investors. It’ll probably be a gimmick rather than mainstream, but what a powerful signal it would send.

Sometimes I have to pinch myself. I’m not that old, yet even I can remember when the standard way to invest was to pay an advisor a trail commission of say 0.5% a year forever for putting you into an active fund that charged 2% a year. As if that wasn’t enough, you also paid 3-5% as a one-off upfront fee for the privilege.

There are protection rackets with better terms than that.

No wonder we’ve seen a huge shift to passive investing. Active investing is a zero-sum game, so pound for pound, by charging higher fees the average active fund can only lose by comparison. Simple mathematics guarantees that while there may be a few market beaters, the majority will under-perform – just as the evidence confirms.

For the average edge-less investor (that is, nearly everyone) index funds offer the cheapest, simplest, and most likely path to investing wealth.

Of course, as more people understand this, the financial services industry tries to obfuscate the truth to protect its cash cows.

We’ve all read the articles that misunderstand how passive investing works and blame it on every market evil under the sun – from flash crashes to low returns to high volatility to job losses to, well, giving a toehold for Marxism on Wall Street.

More constructively, some have advanced theories as to how active funds can turn back the indexing hoards.

But these generally fail a quick inspection:

  • Some say active funds must work harder to earn their higher fees. But active investing is a zero sum game. Tens of thousands of smart people are already busting their guts. Everyone works harder, pays more, and on a market wide level the under-performance will persist.
  • Active investing should be the preserve of specialist hedge funds, say others. They overlook the fact that hedge funds as a group have delivered worse returns than a cheap 60/40 passive portfolio for more than a decade. And with over $3 trillion under management they’re no longer niche.
  • Just wait for a crash! Then active funds will prove themselves over dumb index funds that will follow the market down! This overlooks the fact that active funds are the market. (Did someone say zero sum game?) Falling markets are caused by active funds selling shares, or at least being prepared to pay less for them. Where active funds do better in falling markets it’s typically because they always hold a wodge of cash ready for client withdrawals, not because of skill. Cash keeps its value. You can mimic this brilliant strategy by keeping some money in a High Street savings account, and save on the fund fees.
  • A few optimistic people say the industry as a whole should pay for the price discovery service that active managers perform, which index trackers exploit for free. As long as active managers are the ones driving around in sports cars there’s zero chance of that happening.
  • Some say active investing needs to be reinvented through simple Factor Investing / Smart Beta / Return Premium funds. These enable investors to buy into something supposedly more concrete than ‘magical’ manager skill. A retort is that factors may not persist – our own contributor Lars Kroijer is one skeptic.

That last is already happening, anyway, through the proliferation of factor-based ETFs. Their undeniable advantage versus traditional active funds (though not the cheapest market-weighted trackers) is they’re less expensive to run.

Computers don’t demand sports cars!

Active funds must cut costs to compete with zero

I believe that cost cutting is the only way that active funds can compete long-term.

The reason active funds do so poorly as a category is that in a zero-sum game, their high fees gnaw away at their returns.

Before costs are taken into account, there is a share of money in active funds that does beat the market – which is balanced by an equal weight that loses.

The net result is the market return (which is captured most cheaply and consistently by passive funds).

If active fund managers leveraged technology to cut costs across their businesses, they might be able to reduce their total expense ratios to best-in-breed pricing of say 0.3% or less.

That would still be two to three times as expensive as a decent equivalent index fund (let alone a free one) but at least it’d be competitive.

Many people seem to believe they deserve to beat the market. And they like humans managing their money more than machines. Passive investing feels wrong. That’s why the active industry persists.

If active funds were much cheaper, these notions wouldn’t be so consequential, and the case for choosing a tracker over a ‘fun’ flutter on a flavour-of-the-month manager would be weakened.

I don’t say that it would be logical for the average investor to then choose active – they’d still on average lose to the market. But it’d be much less potentially damaging.

Slashing costs – that’s the only proper way for active to compete long-term.

Actively foolish

The industry though continues to prefer an alternative route of spreading fear and confusion to try to salt the earth for passive funds.

Just last week saw another doozy in the Financial Times.

The article – Passive Investing Is Story Up Trouble1took a machine gun to modern markets. Albeit a machine gun filled loaded ping pong balls.

The result was a lot of random seeming attacks bouncing everywhere and missing their target.

The piece attacks robot traders for their supposedly indiscriminate – or at least business-agnostic buying – before strangely conflating their activities with passive investing.

Investors in index funds and ETFs are also lamentably clueless, the author implies, pushing up the most popular stocks with their relentless buying.

Never mind that many a robot’s algorithmic strategy is focused on company fundamentals, via the factor investing I mentioned above.

And never mind that – for the gazillionth time – money that flows into the big market-cap weighted funds does not in itself distort prices. That’s not how it works!

Market cap weighted index funds follow the prices set by active investors.2

Anyway, even the allegedly witless robot traders who follow price signals are not just waving their steely fingers in their air. Prices contain information, whether it’s a shortage of cocoa that pushes up the price of chocolate bars or a surplus of some high-flying tech stock that people want to dump after a terrible trading update. A robot trader’s algorithm is not ‘think of a number between one and a hundred and pay it’.

But perhaps the biggest laugh is the implication that passive investing and automated trading has brought imminent ruin to a previously calm money-making oasis.

Stock markets boomed and blew up for a hundred years fine without index funds or robot traders. Flash crashes are dramatic and unsettling, but they last a couple of hours – manias and funks driven by human emotions can persist for decades.

If the big gains we’ve seen for US tech giants like Apple, Alphabet, and Amazon are priming the stock markets for an imminent rout (and I don’t think they are, incidentally) then it will be because active investors set too high a price for those shares – not because passive money dispassionately followed it.

And when the dust settles after the next crash – and there will be a next crash – we’ll see how well these active gurus sidestepped the alleged silliness they see today.

Perhaps a bevvy of skeptical active funds will smash the market and vindicate their high fees?

I wouldn’t hold your breath.

  1. [Search result] []
  2. The one quirk is when a company enters or leaves an index that is being tracked, there can be a price impact from passive fund trading and those who anticipate it. But that is a one-time event, is rarely what’s being attacked, and the overall affect is relatively small. []
{ 29 comments… add one }
  • 1 2021er August 9, 2018, 11:23 am

    Things I’d tell my younger self – don’t invest in high-fee active funds and don’t buy with-profit endowment policies.

  • 2 John @ UK Value Investor August 9, 2018, 12:40 pm

    From the CFA institute’s Standards of Professional Conduct:

    “Members […] must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.”

    Not sure how high fees and multi-million pound salaries extracted from assets under management equates to placing clients’ interests before their own.


  • 3 bob August 9, 2018, 12:42 pm

    Can anyone explain to me in practical terms the difference between the Fidelity Index World P Acc (Accumulation) and the Fidelity Index World I Acc (Accumulation) except that the latter charges 0.15% OCF rather than 0.12% for the former?

    I’ve been buying the “I” fund for years (topping up a further £3k yesterday) only to realise today (thanks to this article) that I’ve been paying an extra 0.03% for what appears to be an identical fund.

    It’s a bit like someone telling you that your fly is undone – you’re kind of glad they told you but life was better before they did.

    The “P”

    & the “I”

    I have vague memories of professional versions of funds but I thought the days of two different versions of the same funds at different prices had long since disappeared.

  • 4 raluca August 9, 2018, 1:59 pm

    Oh, to be an US investor right now! Unfortunately, my home market only offers ETFs with a 3% buying fee and a 1% yearly fee. I’m practically forced to become an active investor at these prices.

  • 5 Naeclue August 9, 2018, 3:06 pm

    Great article. The big lie (or should I say fake news?) in the FT story is this

    “Passive investments, such as exchange traded funds (ETFs) and index funds, similarly ignore fundamentals. Often set up to mimic an index, ETFs have to buy more of equities rising in price, sending those stock prices even higher.”

    Either the author is ignorant that this is twaddle, in which case other stuff she writes is probably twaddle, or is she is deliberately trying to undermine index trackers/ETFs by spreading false information. Hard to know which, but no matter, as economists are towards the bottom of the pile of people I would pay any notice of when it came to making investment decisions.

  • 6 Accidental FIRE August 9, 2018, 3:57 pm

    I posted about the free Fidelity funds and to me the bigger value is that they have no minimum. Vanguard has minimums of $3k or $10k to get in their two total market funds. The Fidelity funds are a great option for a newbie investor out of college or a low income person who only has a few hundred dollars to get started.

  • 7 Hari Seldon August 9, 2018, 5:11 pm

    There are potential problems following an index when Mr Market is behaving ‘oddly’

    Eg late 1980’s when Japan was around 40% of the world market based on P/E ratios of 100:1 etc

    I prefer having a collection of regional trackers that are weighted on a basis representative of the average weighting over several years, rebalancing between the regions.

    Such problems are infrequent but should not be ignored and a mantra of Passive Good , Active bad is unhelpful, very low cost active investing following a sensible policy could work just fine.

    The Vanguard factor ETFs are basically just that, low cost, active selection and tuning of algorithmic based investing. Unfortunately most active funds are not great but they are likely to survive and hopefully they will at least get cheaper.

  • 8 dormouse August 9, 2018, 5:50 pm

    Oooh I like this idea,

    “collection of regional trackers that are weighted on a basis representative of the average weighting over several years, rebalancing between the regions.”

    (but don’t have enough money invested to have several funds to rebalance!) What would the weights be at the moment? I’m concerned with the dev world tracker that I may now have far too much in the US….

  • 9 Joe 45 August 9, 2018, 7:12 pm

    I’m 95% there on trackers but would be grateful for help in understanding the “zero-sum game” aspect. Using an extreme example, let’s say there is only one fund. It holds one stock which happens to grow 10% in the year. The market average was 7%. Where is the “loser” is this scenario to balance the winner?

  • 10 Quitting Teaching August 9, 2018, 8:05 pm

    So if you invested £100 in 1000 different active funds, then the average return of all these funds added together would be the market average of say 7%. With the increased active fees acting as a headwind, this slows the growth to be less than average, on average.

    This passive investing stuff all assumes that none of us diy investors have an edge, which is a correct assumption. I am too busy planning and teaching lessons, walking the kids,bathing the kids, marking books to do the research required to claim I have an edge.
    So if you know for certain which funds will be the ones that outperform the market next year, over the next decade, in perpetuity, let us all know and every reader on this site will ditch our passive investments immediately! All funds perform in a zero sum game back to the market average, but their fees fuck you over time.

  • 11 Naeclue August 9, 2018, 8:33 pm

    @Joe 45, A very extreme example, but if everything is in cap weighted trackers apart from one fund with one stock, there must be active investor(s) somewhere short that stock. The index funds cannot (by definition) be below weight one stock, so there must be at least one market participant, an active investor, prepared to short the stock. You cannot have a market with only one active participant, unless there is only one stock listed on the market.

    Whoever is short will have borrowed the stock position either from the “active” fund, or from the trackers, or both. The active fund would have gained at the expense of whoever has taken the short position.

  • 12 Jumbo August 10, 2018, 6:21 am

    But if you are solely invested in this single fund you are still very happy, aren’t you? You don’t care about the average because you don’t own the average.

  • 13 Gentleman's Family Finances August 10, 2018, 8:31 am

    Two things that I’ve learnt from investing:
    1) don’t try to pick individual shares
    2) don’t let anyone else do the same

    The long term savings of index trackers will really add up but I do wonder if the rewards you can reap from investing money into a growing business – helping it become bigger and more valuable and selling for a profit are being forgotten.

  • 14 The Investor August 10, 2018, 8:40 am

    In this example (which is so extreme I’d question its utility to be honest 🙂 ) we have three groups of investors — the tracker fund people who get the market average of 7%, the active fund which owns that one stock that goes up more and gain 10%, and an active fund which is short the stock and so does worse than the market. (We can’t say by how much it under-performs on this information because it could own the market except for that one stock it is short, and we don’t know how much money is in this losing active fund relative to the active winning fund.)

    In this example 50% of active investors (or 50% of the active weight of money, more specifically) are presumably happy (because they beat the market) and 50% of active investors unhappy (because they lost to the market). Whereas all the passive investors are presumed satisfied.

    Both active funds will have charged higher fees than the tracker though. Over time the two active funds will probably swap this winning bet / gains / happiness between them (that’s what we see in the real world — sustained out-performance is vanishingly rare) but the higher fees that mean that *as a group* they lag the tracker will be consistent. Tracker fund investors will keep getting their market return cheaply, and presumably remain satisfied.

    Nobody is saying it’s not better to own a winning fund. It definitely is! 🙂 The odds are massively against you being consistently invested in the winners though. The numbers speak for themselves, as some quick research (or some of the links in my article above) will show.

    If you feel lucky and/or you believe you have edge then by all means go for it. I’m a purist about the underlying case for passive, but not how people respond to it. (I’m an active stock picker, as long-time readers will know. More here: http://monevator.com/passive-vs-active-investing-episode-1/)

    I’d go back and read the active is a zero sum game article linked to in the article, also. It goes into the detail on all this.

  • 15 Stu August 10, 2018, 8:51 am

    The loser is everyone else in the market who, in aggregate, were slightly less invested in your example fund, because of the holdings that you had. Their average would be a tiny amount below the market return (but they are massive) to make up for your moderate outperformance (where you are small).

  • 16 Naeclue August 10, 2018, 8:55 am

    @Jumbo, yes if you hold the fund you should be very happy. If the single stock it holds goes on to underperform the market, lose money, or goes bust, then I suspect you will not be.

  • 17 Naeclue August 10, 2018, 9:05 am

    @Stu, No that only applies to those underweight the stock – other active investors. Those holding tracker funds will not be underweight and so will get the market return (less a small amount to cover tracker running costs).

    As mentioned in the article though, if a tracker fund has leant the stock, then it is possible for that particular tracker to outperform the market due to the lending fee.

  • 18 Stu August 10, 2018, 9:37 am

    @naeclue Indeed – hence why I said the rest of the market in aggregate. There may be many active investors, or very few. The point is that your outperformance comes at the cost of them, as a group, under performing.

    Within that group, some will precisely match the market return, some will do better than you, some worse. For you, it is irrelevant.

  • 19 Owen Thomas August 10, 2018, 12:24 pm

    I am still trying to understand the main criticism of index funds. Apologies if my thoughts are a bit scattered, I’m just trying to understand the main criticism, and why this is invalid.

    Is the FT article saying that there is a point where the inflow of money from index funds starts to prop up the market share, purely based on the fact that the stock already has the largest market cap, rather than priced on current fundamentals and you end up with a run-away market?

    However, presumably active funds would start to short the stock if index funds began to over-buy, therefore active funds correct the price? As long as active funds exist, the price will be set by active funds?

    Is there believed to be some sort of tipping point in the mix of active-index funds, where active funds are no longer able to correct price? Or perhaps a scenario exists where index funds are always buying over valued shares, and active funds are able to consistently correct for this, meaning the index funds become a loser and the active funds become winners again?

  • 20 Tony August 10, 2018, 4:47 pm

    This line of your article “Simple mathematics guarantees that while there may be a few market beaters, the majority will under-perform – just as the evidence confirms” links to this 2014 Monevator article “Why passive investing wins in the UK”. Whose first line is now so prescient: “My mum asked me if she should invest in Neil Woodford’s new fund. Like a bedazzled groupie she doesn’t stand a chance, given how he’s been marketed like a rock star who can print money.”
    It’s so apt in light of his fall from favour/under performance. Although you could argue this is exactly what you would expect. Ie fund management is at best informed gambling so the odds are against long term market beating performance. And/or few active fund managers beat the market long term.

  • 21 Adam August 10, 2018, 6:33 pm

    Sorry if I’m being thick. I hold a combination of active funds, passive funds and individual stocks and I’ve always had the same problem understanding index trackers. Concerning cap weighted index trackers – an index tracker holds every stock in the index in the same proportion as the index – correct? This means any new inflow of money is invested in the same ratio as the index so it doesn’t bump up the price of any individual stock it bumps up the price of the whole index – if it can move it at all.

    My favourite index tracker is the Vanguard FTSE Developed World ex UK tracker. If we all collectively pumped a billion pounds into that fund it’s barely going to affect the value of the index considering Apple makes up >2.3% and is valued at >£800 billion.
    So investing in index trackers doesn’t affect the value of the index at all does it? If we collectively tried to buy a billion pounds of Apple shares it would affect Apple’s share price. A crude calculation suggests that the FTSE Developed World ex UK index is worth about 40 trillion pounds – surely we passive investors can’t pump enough money into the index to move it at all.

    So, if I’m understanding things correctly, all this talk about passives causing potential bubbles or runaway share prices is utter nonsense. An active fund manager or hedge fund dealing heavily (long or short) on a single stock would affect it, but would have no effect on the index itself.

    My advice to young investors would be invest in a cheap global index tracker and forget about it until you retire. Sounds sensible?

  • 22 Naeclue August 10, 2018, 7:22 pm

    @Adam, investors pouring large amounts of money into a tracker can certainly move the price of the shares in the index up, but what they cannot do is inflate the price of Apple shares more than say Halfords shares, which is what the FT article and others like it are claiming. That would only happen if the tracker was not cap weighted and it overweighted the proportion of shares in Apple. A cap weighted fund does not do that, it weights proportion of shares equally, so if a global tracker held 1% of all Apple shares, it would also hold 1% of all Halfords shares.

  • 23 John B August 10, 2018, 7:36 pm

    Passive trackers account for about 20-30% of the global markets now. So its not really a case of ‘new’ money coming from outside the markets, its more active investors switching to passive. As the sum of those active funds is 80% of the market, the movement should be neutral for prices, unless some active funds, say income ones, are preferentially being abandoned.

    As share prices are set by “market clearing prices”, I think we could get passive up to 80% of the market before the active market makers stop determining the prices. So its far too early to worry, unless you are the Telegraph stocking picking columnist, worried that your advice is no longer valuable, so you run scare stories about trackers. Always check the vested interest behind financial stories.

  • 24 Owen Thomas August 10, 2018, 10:00 pm

    thanks @John B so your understanding its 80% ratio before index funds start to manipulate price. at that point its hard to know what will happen, but even then it could be better to be in index because the tracker is inflating prices in then index which you’d want to have exposure to anyway,

  • 25 John B August 10, 2018, 11:18 pm

    As far as trackers changing prices, they could do it because of 2 factors

    1) Trackers’ lower fees make equity more attractive, so money flows in from cash/bonds, and indexes rise. More capital in equity should make that part of the economy grow.

    2) Trackers’ lower fees mean less money is sucked out of funds. Of course those fees go to making the profits of financial companies, so lower fees mean those equities fall in value, so that part of a tracked index falls. Its not zero sum though, as managers’ wages and lunches are a drag on the system.

  • 26 Joe 45 August 11, 2018, 6:15 am

    A friend of mine is a trustee of a (relatively) small pension fund. The trustees wanted to invest in passives but were advised that they were under a legal obligation to engage an active manager to “look after” the money.

  • 27 The Investor August 11, 2018, 12:38 pm

    @Owen — No need to apologise, this stuff is more mind-bending, or at least counter-intuitive, than it first appears. And I think we need to do a new article specifically about distorting prices that we can point people towards. I tried to cover it in my zero sum game article, but probably worth delving into the detail.

    Firstly, when we say index trackers don’t distort prices, we are always talking about a vanilla *market cap weighted* index funds. Anything else — equal weight, Smart Beta, etc — could distort prices, as they are taking a position that is not equivalent to the market. But a market cap weighted index fund is in theory market neutral.

    A good analogy I’ve heard before is of a seesaw. Adding people on either end of the seesaw will make one side go up or down relative to the other. But someone standing exactly in the middle shouldn’t have any impact. In simple terms that’s what a market cap weighted index fund is like in the market. (In practice it’s not quite so clean cut but it’ll do for big picture stuff).

    A second thing to appreciate that is obvious once you think about it is that active funds — in aggregate — ARE the stock market, weighted by market capitalization. Some will own more of share A and fewer of share B, some may go short by borrowing share C from somebody and selling it short, but all the shares are in somebody’s hands — and together they make up all the market that is not held by market cap weighted index funds. The latter own the rest of the shares and are by definition market cap weighted. Bottom line, the whole market is market cap weighted.

    Now imagine a market cap weighted index fund exists today with say £1bn in it. It owns shares in proportion to their share by market capitalization of the market. Critical to note is that it DOES NOT need to buy or sell shares just because prices go up and down. You see this stated all the time, it’s obviously not true. If it owns say X shares of Apple to reflect Apple’s market cap, and the share price of Apple goes down, reducing its market cap, then the value of the X shares owned by our index fund declines in parallel. Ditto if prices rise. So a market cap weighted fund does not need to buy or sell to reflect prices changing. (This is one reason why costs are so low).

    One time it does need to buy or sell shares is if a company enters or leaves the index. It owns no shares, so can’t reflect that company’s ongoing rise or fall, so it needs to go out into the market to buy them. To do this, it needs to acquire them from other non-indexing participants. This represents extra demand in the market and has been shown to distort prices to some extent (a few percent, say) in a ‘pop’ or ‘drop’ when index reshuffles are announced. Note this happens at the bottom end of the market cap weighted index, usually (except in cases of IPOs) so its overall impact is probably pretty small. There are also hedge funds and other arbitragers trying to exploit these potential anomalies, which means over time they will shrink (because prices of companies looking like they might go into the index will rise well in advance) but nevertheless, there’s some distortion here.

    The other time a market cap index fund has to buy or sell — relevant to the ‘wall of money going into index funds’ criticism — is when it has new money from an investor. We’ve seen it doesn’t need to trade to reflect rising or falling prices. But a ‘physically replicated’ market cap weighted fund does need to own shares proportionate to the money its investors have given to it. This means means if it goes from £1bn in funds invested to £2bn it needs to buy an extra £1bn worth of shares.

    This is what some critics are claiming distorts prices. That billion now has to be invested ‘blindly’ into new shares, per their weighting in the index. And for market cap weighted funds, that means most of the new money needs to go into the biggest companies (who have the largest market caps). Doesn’t that distort prices?

    Broadly, simplifying, no. Here’s why. Remember that for every buyer of a share, there has to be a seller. Every share is already owned by someone, remember? And I’ve already shown that in total, all the owners (the index funds plus all the active funds) equal the market cap weighted index. Over-simplifying, if you could freeze the market for a nanosecond then prices should be in equilibrium. If active managers thought some of their shares should be sold for more than they are currently priced at, they would have bought more. If they think they’re expensive, they should have sold. It’s obvious this is an over-simplification for any one manager in any one nano-second, but over the market as a whole it is broadly true.

    So when an index fund goes out to buy shares, it buys either from another market cap weighted index fund that has seen fund outflows, so needs to reduce its holdings, or else it buys from active managers who *in aggregate* are happy to sell at the market price because they are the market. Because the index fund is market cap weighted, it won’t pay more or less, it just wants to buy in proportion to the market cap weighted index. So there’s no price distortion, in theory.

    This is different with an active fund. If active fund A decides Apple shares are worth more than they are trading for, then it has to be prepared to pay more than the market price to prize them out of fund B’s hands — because at the current price fund B is a happy holder. Similarly, if fund B wants to sell shares in Tesco, it will need to price them at less than the going rate, because everyone is a happy holder at the going rate.

    Market makers (these days computers) sit in the middle of all this to match up these active buyers and sellers, at prices where they can agree to trade shares. This is the process known as “price discovery” and it is the vital role that active fund managers play in trying to figure out as best we can what any company is worth (based on an estimate, always changing, of its future cashflows).

    Price discovery obviously changes prices. If fund A wants to own twice the weighting of Apple shares, it needs to pay a price that will induce some other fund(/s) to in aggregate own half the market weight. But market cap weighted index funds do not seek to own more than the market weight of any company. So they don’t bid up or down prices.

    Now, all that is the theory, as best I understand it / can explain it. (And I stress I am not a finance professor! Worse, I’m an active investor. 😉 )

    I do concede that with trillions of dollars sloshing around in the real world, where £1bn cannot be invested in a nano-second, where there are trading costs, where there are people trying to guess what other market participants are up to, where there are some technical issues such as forced sellers and so forth — I do believe that probably does mean the hundreds of billion dollar index funds probably do very slightly distort prices, perhaps, maybe, to a small degree. But I’ve only really read seen any evidence offered of it demonstrably happen in very illiquid markets — the very opposite of the huge markets and tech giants where the critics are pointing their finger!

    Going back to our seesaw analogy, if someone stands on the seesaw they probably can’t be completely 100.00% rock steady, and there probably is a bit more friction and so on. But rounding up you can generalize to say they don’t impact compared to the changes of putting Billy Bunter who ate all the pies on one end and super lean Jack Sprat on the other.

    The difficulty, as John B alludes to, will come if/when so many index that the weight in the middle of market cap funds is so vast that it somehow hinders the impact of price discovery. This is what people mean when they say you need 5/10/20% of the market to be active. I think it’s a valid concern, but we’re clearly not there yet.

    Also, you have to ask a simple question — if ‘dumb’ market cap weighted funds are distorting prices away from fundamentals, then why are ‘smart’ intelligent buyers not profiting and putting up better numbers?

    Partly I’d say because active is a zero-sum game (so overall the winners would be balanced by the losers) but it’s not like we’re seeing a huge swathe of winners exploiting these supposed efficiencies.

    A simpler answer is because to all intents and purposes index funds are not distorting prices, and so there’s no inefficiencies there to exploit. 🙂

    Hope this helps!

  • 28 Chris August 18, 2018, 2:09 pm

    Fascinating stuff.

    If you can bear one more analogy… is the case that passive funds don’t influence the market because:

    1. It’s a bit like going to a fruit stall in a market and buying one of each item of fruit available


    2. It’s like going to a fruit stall in a market and buying one of each item of fruit depending on how many of each is available – so if the the number of oranges available is double the number of each other fruit then the index buys twice as many oranges?

    Regardless: by extension is it a bit like going to a supermarket and literally buying everything that’s on offer – so the value of no single item is driven up by demand (albeit some items may be in shorter supply than others)

    As I say – apologies for yet another analogy but I find this whole debate really interesting and would love to be able to grasp the basics

  • 29 Naeclue August 19, 2018, 10:09 pm

    @Chris “It’s like going to a fruit stall in a market and buying one of each item of fruit depending on how many of each is available – so if the the number of oranges available is double the number of each other fruit then the index buys twice as many oranges?”

    That is exactly what it is like. You don’t buy more oranges because they are more expensive, you buy them simply because there are more of them. Now if apples are more expensive than other fruit, you will spend more of your money buying apples, but you still only buy 1 apple for every 2 oranges. This is the bit that many commentators fail to grasp, either deliberately or through ignorance and why buying according to availability, which is the same thing as buying by market cap, would not drive up the price of apples more than it would oranges.

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