Don't Blame Indexing for GDP Slowdown
A tweet that recently caught my eye asked whether it was any surprise that economic growth has decelerated as the popularity of passive investing has risen.
Manyreaders will automatically dismiss this linkage as an example of the famous post hoc ergo propter hoc fallacy. (Y followed X, so X must have caused Y.) Basic economic theory tells us that GDP growth equals growth in the workforce plus productivity gains. By arithmetic, then, the greying of the U.S. population made it inevitable, barring a remarkable surge in productivity, that GDP growth would decline from the years in which Baby Boomers entered and remained active in the workforce.
Itturns out, though, that the possibility of a link between indexing and declining GDP growth has attracted some attention in reputable quarters. For example, a 2016 New Yorker article on the topic cited research conducted at Harvard Law School, University of Washington, Washington University, University of Michigan, and Goldman Sachs’s investment management division.
One strand of research discussed in the article preliminarily found that passive investing sends distorted signals on commodity prices, causing disruption in production costs, inventory, and profits. A contributor to this work helpfully provided a “theoretical example” involving cocoa beans. The article’s author then broke entirely free of empirical evidence to assert, “ It’s not hard to imagine large-scale passive investments warping the stock market in similar ways.” (Italics added.)
A 2018 MarketWatch article argues that in some unspecified way, the growth of index funds has impaired the quality of securities analysis being performed by active managers. The result, warns the author, is that stocks will cease to be priced correctly, making capital less likely to flow to innovative, efficient companies such as Amazon.com.
With AMZ up 63% since year end versus 0% for the S&P 500 (through July 24), the online retailer colossus is presumably unworried about being shut out of the capital markets should its management desire to raise new funds. Ironically, Amazon’s highly disproportionate runup, along with the likes of Apple Microsoft, and Netflix, has been assailed as an unhealthy lack of market breadth brought about by… indexing.
The notion that misdirected investment can impede GDP growth is sensible enough. It is not self-evident, however, that passive investing represents “a gross misallocation of capital,” as asserted in the tweet that prompted this post.
Yes, index funds are price-takers, performing no independent analysis to decide whether their BUY candidates are cheap, fairly valued, or wildly overpriced. Moreover, their share of total stock market value has grown, now accounting for about half of the equity holdings of mutual funds. Index funds’ role in setting prices is limited, however, by their low turnover.
In the 2019 book Wealth of Wisdom , edited by Tom McCullough and Keith Whitaker, Charles Ellis calculates that even if index funds were to attain an 80% share of all equities (not just those held by mutual funds), they would account for less than 5% of trading. He finds it hard to believe that active managers’ effectiveness in price discovery would be materially compromised if they were still doing more than 90% of the trading.
Let us turn back to what has happened so far. Proving that the rise of passive investing has caused, rather than merely coincided with slower U.S. GDP growth would require a cross-border comparative study. The research would have to show that the countries in which indexing has made the smallest incursions are the ones that have experienced the least deceleration in GDP growth, normalizing for all other determinants of growth rates. Until such a study is peer-reviewed and published in a well-respected journal, critics of passive investing are best advised to exercise caution in drawing connections with economic performance.
As Chief Investment Officer of a firm engaged in active management, I have no special brief for indexing. All investors, though, have an interest in understanding how markets work in reality, rather than in the minds of portfolio managers who regard passive investing as a competitive threat that must be exterminated. The surest way to achieve such understanding is to avoid logical leaps, relying instead on rigorous, data-driven analysis.
