What If Everyone Indexed?

I see this question more and more as indexing grows in popularity.  People generally think that more indexing will make the markets  function less efficiently .  I don’t think this is true at all.  Unfortunately, the question and its answers are usually shrouded in misunderstandings about how assets are priced and myths about what it means to invest “passively”.  So, let’s think about this from an operational perspective.

An index fund is not really an “index”.  They are portfolios managed every day trying to track an index.  These funds are managed actively and involve hundreds if not thousands of decisions every year.  The simplest example is the modern day ETF which is essentially a real-time version of what most people think of as an index fund.  When you buy shares in an ETF there is someone who is actively managing the allocation of funds (the same is true for an index mutual fund though it’s less apparent in real-time since the fund is not traded on an exchange).  For instance, if the market price of an ETF were to deviate from the intraday indicative value then the market makers would either buy/sell the ETF or buy/sell the underlying securities. So, while there doesn’t appear to be much activity on the surface, the very act of buying an index fund could actually force some active management in the underlying securities markets.  In other words, your “passive” investment is the other side of the active management of the market maker or fund administrator.¹

It’s not a coincidence that high frequency trading firms and big banks are making huge gobs of money during the rise of passive indexing.  After all, passive indexing means that there is a greater need for those alternative forms of what is nothing more than “active” management. Unfortunately, the studies blasting active management usually include mutual fund managers and not the most active managers of them all – market makers and HFT firms.  And make no mistake – these “active” operations are hugely profitable because they are essentially making “passive” portfolios available.²

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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