Last Updated Mar 23, 2011 3:40 PM EDT
One of the questions I'm most asked is: What would happen if everyone indexed? What those asking really want to know is would a passive strategy still work.
Before we launch into this discussion, there are a few things to keep in mind. Even if every investor adopted a passive strategy, there would always be some trading activity from the exercise of stock options, estates being liquidated, divorces, mergers and acquisitions, etc. Plus, companies would remain active buying/selling other companies even if individuals stopped trading stocks. With that in mind, let's deal with the real issue -- will active managers gain an advantage if the trend toward passive management marches on?
Let's first address the issue of information efficiency. With less active management activity, fewer professionals will be researching securities, theoretically making it easier to gain a competitive advantage. This is the argument made for active investing in small-cap stocks and emerging market stocks -- they're inefficient asset classes. However, active managers' underperformance against proper benchmarks has been just as great (if not more so) in these asset classes as it has been in the large-caps, as trading costs are greater in these "inefficient" asset classes.
Less-efficient markets are typically characterized by lower trading volumes. Lower trading activity results in less liquidity and greater trading costs. If more investors shifted to passive management and trading activity fell, liquidity would decline and trading costs would rise. The increase in trading costs would raise the hurdle active managers have to overcome to outperform -- which is why we don't see evidence of persistent outperformance beyond the randomly expected in small-cap or emerging markets stocks. William Sharpe demonstrated in his famous paper "The Arithmetic of Active Investing" that:
- "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
You'll note that Sharpe doesn't even mention the argument about market efficiency. John Bogle calls it the "Costs Matter Hypothesis."
There's another interesting conclusion that can be drawn about the trend toward passive investing. Remember that for active managers to win, they must exploit the mistakes of others.
Imagine the following scenario: You're an NBA player. The league is holding a free-throw shooting contest open to all players. Each participating player will take 100 shots, receiving $100 for each shot made. You can either shoot or accept the average score of all players who participate. The best free-throw shooter in the league shoots about 90 percent, the average player shoots just 65 percent, and you shoot 80 percent. Should you compete or accept the average score of those who participate?
Since you shoot an above-average percentage, it seems like you should play. However, the fact that you're above average is irrelevant because all those with a below-average shooting percentage should choose not to play. Anticipating this occurrence, even those with above average scores should decide not to play. Logically, only the player with the best percentage should choose to play, and everyone now has an expected return of $9,000.
What does this scenario have to do with investing? It seems likely that those abandoning active management in favor of passive strategies will be investors who have poor experiences with active investing. Thus, it seems logical to conclude that the remaining players are likely to be the ones with the most skill. (If investors' outperformance was based on luck it will eventually disappear and they will abandon the game.) As less-skilled investors abandon active strategies, the level of competition among the remaining players increases. Thus, unless you happen to be Warren Buffett (the equivalent of the best free-throw shooter), the winning strategy is not to play. Instead the winning strategy is to accept market returns.
More on MoneyWatch:
Can You Exploit the "Inefficient" Indian Market? The Costs of Active Management Can You Find the Future Winners? 5 Reasons to Avoid Variable Annuities Quest for Alpha: What You Need to Know When Handling Your Own Investing
Three ways I can help you become a wiser investor: