It is once again fashionable to blame the humble index fund for all the ills of the world.
Indexing has become a major global financial force as a form of passive investment that aims to match the market rather than beat it. And in doing so, it has raised the ire of some of the world’s most famous investors.
The latest charge is that passive investing has caused the U.S. stock market to become obscenely concentrated in a handful of colossal tech stocks known as the Magnificent Seven.
Indexing has previously been called out for inflating asset bubbles. For breaking the financial markets. For being “un-American.” And for undermining the principles of capital allocation crucial to a free-market economy.
Fear not. Your index fund is not destroying capitalism. The accusations have never held up to close scrutiny, and neither does the latest round.
Indexing haters tend to offer up variations of the same theme – that passive funds take no view on the true value of a company. Instead, they dumbly shovel money into stocks according to their weightings in the index.
In 2016, asset management firm AllianceBernstein put out a note titled: “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” It argued that passive markets are even worse at allocating capital than a centrally planned economy.
Among the detractors are some of the investing world’s biggest names: Carl Icahn, Howard Marks, Seth Klarman, Cathie Wood, Michael Burry, Peter Lynch. A few months ago, famous hedge fund investor David Einhorn said the passive investing boom has “fundamentally broken” the financial markets.
Of course, a common thread linking all these names, aside from their success, is that they are all active investment managers.
The rhetoric has veered into the absurd. If you are among the hordes of index fund converts, there is a billionaire investor somewhere that thinks you’re more traitor than trader.
Lately, the vilification of indexing has spilled into the mainstream. The June cover of Harper’s Magazine posed the question: “Will passive investing spell catastrophe?”
The argument is that the bigger the stock, the more passive money it attracts, which further pushes up their share prices, creating a dangerous feedback loop. Exhibit A, the narrative goes, is that seven tech giants – Apple Inc. APPL-Q, Amazon.com Inc. AMZN-Q, Alphabet Inc. GOOGL-Q, Meta Platforms Inc. META-Q, Microsoft Corp. MSFT-Q, Nvidia Corp. NVDA-Q and Tesla Inc. TSLA-Q – now account for around 30 per cent of the S&P 500 index.
Big Tech profits have dwarfed the rest of the stock market
Growth in earnings per share (EPS) of the Magnificent Seven stocks vs. the rest of the S&P 500
EPS growth index (2014 =1)
Magnificent
Seven
6
19.4%*
5
4
3
2
S&P 493
4.1%*
1
0
2014
2017
2019
2021
2024
*Annualized growth rate as of May 31, 2024
SOURCE: GMO QUARTERLY LETTER 2Q 2024
Big Tech profits have dwarfed
the rest of the stock market
Growth in earnings per share (EPS) of the Magnificent Seven stocks vs. the rest of the S&P 500
EPS growth index (2014 =1)
Magnificent
Seven
6
19.4%*
5
4
3
2
S&P 493
4.1%*
1
0
2014
2017
2019
2021
2024
*Annualized growth rate as of May 31, 2024
SOURCE: GMO QUARTERLY LETTER 2Q 2024
Big Tech profits have dwarfed the rest of the stock market
Growth in earnings per share (EPS) of the Magnificent Seven stocks vs. the rest of the S&P 500
EPS growth index (2014 =1)
Magnificent
Seven
6
19.4%*
5
4
3
2
S&P 493
4.1%*
1
0
2014
2017
2019
2021
2024
*Annualized growth rate as of May 31, 2024
SOURCE: GMO QUARTERLY LETTER 2Q 2024
But there’s a very good reason Big Tech has swallowed the stock market, and it has little to do with index funds, Boston-based asset manager GMO noted in the latest edition of its widely read quarterly investment letter. Over roughly the past 10 years, the Magnificent Seven has collectively generated earnings growth of nearly 20 per cent annually, according to the report. The remaining 493 names? 4.1 per cent.
It’s corporate fundamentals driving the tech frenzy, not some corruption occasioned by passive investing.
“The impact of passive investing in markets has been overblown,” writes Ben Inker, co-head of asset allocation at GMO. He adds that indexing cannot, as its critics allege, “change the basic math of investing.”
But passive investing has, Mr. Inker admits, undeniably reshaped the investing landscape over the past two decades.
At the root of the upheaval are two eternal truths that have dawned on the investing masses. One, it is extremely hard to beat the market, even for the pros, and it’s next to impossible to do it consistently. And two, investment fees are silent portfolio killers.
The passive approach, in its purest form, makes no attempt to pick the market’s winners and instead emulates the performance of the entire market at the lowest possible cost. Today, a Canadian investor can buy, with a few clicks of a mouse, an exchange-traded fund that approximates the S&P/TSX Composite Index while charging a minuscule management expense ratio of 0.05 per cent.
Similar products around the world have lured in trillions of dollars over the past 20 years at the expense of active strategies. Globally, passive funds now dominate capital flows and control about 40 per cent of the assets in retail ETFs and mutual funds, according to data compiled by PWL Capital at the end of 2023.
It has been a monumental shift of wealth that many of industry’s incumbents have loudly resisted.
The impact of indexing on prices is more plausible, however, when it comes to small-cap and value stocks, which have indeed been deeply out of favour for years, GMO argues. But even here, the effect is limited to the timing of returns, not their ultimate level.
If value stocks trade at “too wide a discount to the market as money has moved to passive vehicles, value stocks will outperform in the future,” Mr. Inker writes.
In other words, if the indexing movement has given rise to price distortions in the stock market, that is just the sort of thing a clever active investor ought to be happy to exploit.