Is Indexing Overblown?

Much ink has been spilled over the investor’s migration, more like stampede, to passive investing in the form of index based Exchange Traded Fund (ETFs). This shift has been both applauded and lambasted.

For the former, it’s credited with reducing costs, preventing people overtrading and allowing them to become more patient participants in the long-term uptrend. It’s also likely in that sense to become something of a virtuous cycle, as money is confidently invested in the “market” as a whole, lifting the very indexes people are investing in.

The complaints range from its creating inflating valuations, especially in the large cap names which increasingly account for heavier weighting and more of the gains, to creating the low levels of volatility and ultimately leading to lower returns over time.

A recent article over on The Fat Pitch thinks on both sides are The Worry About Indexing is Overblown.

Here’s what they have to say:

Investors are clearly shifting away from actively managed funds to those based on index strategies. Only time will tell, but this has the look of a durable, secular change in investment management. But much of the perceived threat to market stability of indexing is overblown. Overall, the stock market is still dominated by active management. And while the number of index products has clearly exploded, 96% of these are of insignificant size.

This shift to index-based investing has been blamed for artificially compressing market volatility and for sowing the seeds of future stock market calamity. On balance, these claims seem hugely overblown.

It’s clearly true that there is a shift to index-based investing. Over the past 10 years, approximately $1.4 trillion has flowed into domestic equity index mutual funds and ETFs. About $1 trillion of this money has come out of actively managed mutual funds.

This has the look of a secular shift away from actively managed funds and into index funds: note in the chart above how fund flows did not reverse during the 2008 bear market. In other words, despite a devastating collapse in equity prices, investors added money to index funds and continued to pull money out of actively managed funds. The perceived value of active professional management, even during a tumultuous environment, was poor.

Continue Reading At the Fat Pitch

— The Option Specialist

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About the Author: The Option Specialist