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Against the evils of indexing

(MoneyWatch) George Gilder is an influential supply-side economist who helped launch and shape the Reagan revolution with his book "Wealth and Poverty." In a recent interview with Forbes, Gilder ranted against the problems with index, or passive, investing, making the following assertions:

  • Vanguard founder "John Bogle is a great hero for defining a mode of investment with no possibility of information in it"
  • Indexing provides no possibility of alpha (outperformance relative to an appropriate risk-adjusted benchmark), no upside
  • A market cap-weighted passive investment is always, by definition, backward-looking
  • Venture capital has a strong advantage over what arms-length public investments have become

It's hard to choose which is the most absurd of the claims, so we'll just review them in order and let you decide.

1. There's no possibility of information in it. First, we'll note that active investors do most of the trading. Thus, it's their actions that set prices. And, put simply, the market's price for each security is set by what is called the "collective wisdom" of all investors, each inputting their information into prices with their trades. The price the market sets for each security is referred to as the equilibrium price, where supply meets demand and markets "clear." In other words, it's not that there's no information in the price, it's that passive investors get to be "free riders," while the active investors bear all the costs of the information-gathering process that is so important to allocating capital efficiently.

Here's a simple way to think about Gilder's claim: If he is right in his observations, surely all those smart investors with their insights should be able to outperform an investment with no possibility of information in it. Yet we know that the collective wisdom of the market is a very difficult competitor because the vast majority of institutional investors and hedge funds underperform appropriate risk-adjusted benchmarks.

2. Indexing doesn't provide any alpha. While this is true, what Gilder is missing is that alpha can be positive or negative. And as we just discussed, the vast majority of active investors, both individual and institutional, earn negative alphas. So by accepting market returns, passive investors, while giving up the small hope of outperformance, also avoid the far greater likelihood of underperformance. That's why famed investor Charles Ellis called it the "loser's game." I don't know about you, but I much prefer to play games where the odds are in my favor, especially if the quality of your life may depend on the outcome.

3. Passive investing is backward-looking. Nothing could be farther from the truth. Market prices are set by forward-looking expectations. As new information arrives, prices very quickly adjust to incorporate the new expectations.

4. Venture capital has advantages over public investments. Two of my posts this year showed that there's really nothing special about private equity. Various studies have found that private equity has underperformed publicly available small value stocks. In other words, while investors in publicly held small value stocks have enjoyed all the benefits of total transparency, daily liquidity and broad diversification, they have also outperformed private equity investors, assuming they used low-cost, passively managed funds as their vehicles of choice.

I've made my case against each claim, Now it's time for you to consider them. So, which do you think is the most inaccurate claim?

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