Index Investors Are Evil Freeloaders (Or: Why Vanguard Should Pay SAC And Paulson Royalties)

If you’re reading this, there’s a very good chance that you’re ripping me off. You’re not alone, and I’m not alone, either. Index investors are engaged in massive freeloading at the expense of active investors.

In 2009, the top 25 hedge fund managers took home a collective $25.3 billion. What did they do to earn that? They worked ridiculous hours. They took massive risks. They put their investors ahead of friends, family, and social obligations.

Meanwhile, $SPY investors alone saw a 28% gain for the year, with average assets of about $93 billion. They made roughly $27 billion in profits. All that, thanks to a decision they could make with about fifteen seconds of research, zero reputational risk, no major sacrifices, and no change in behaviour.

Basically, professional money managers are driving themselves crazy—sometimes literally—in order to create a market efficient enough for lazy people to profit. And the lazy people make more.

Indexing Fuels Bubbles

One key ingredient in bubbles is that they genericize something specific. You can’t have a “housing” bubble until you decide that apartments in Tribeca are fundamentally the same as new subdivisions outside of Vegas, or that a company revolutionizing the auction business is the same as a company revolutionizing the pet food business. (This is is part of why the college bubble is still going strong—it wouldn’t be a bubble if it were the Harvard Bubble, and it wouldn’t have gotten this far if we’d called it the University of Phoenix Criminal Justice Degree Bubble.)

Index investing lets someone blindly allocate a chunk of their assets to some fairly generic collection of companies—some worthwhile, many not. Who determines the exchange rate between the worthies and the worthless? Who decides how many Pets.coms you need to match the potential of one Amazon? Once again, it’s the active investors.

Combine this with information assymmetry, and you’ll get massive capital allocation problems. The generic, bubble-ized companies’ managements know their stock is overvalued. Their instinct is to issue shares (or use them as currency) as long as that persists. That, of course means that more and more of the indexified sector is taken up by the lowest-quality companies. Not just the lowest-quality companies, either: the ones that combine low quality with cynical management willing to exploit the market’s misperceptions.

Index investing, and the instincts behind it, exacerbate the natural tendency towards bubbles. We’d still have localised excessive optimism even if we didn’t have index funds. We just wouldn’t be able to act on it so decisively.

Even Worse: Active Investors Don’t Win

The strongest defence of index fund investing is that active investors don’t win. And that’s largely true: analyst projections don’t have strong predictive value, mutual funds underperform their benchmarks, and even hedge funds’ excess profits are largely absorbed by management fees.

That’s a strong defence of individual investors’ decisions to invest in index funds. But that excess performance is only possible if active managers are trading stocks. At some point, someone has to decide that one company is a buy and another company is a sell—if we all invested solely in index funds, share prices would move in lockstep (disregarding liquidity).

It’s like finding out that avid movie theatre attendees have lower disposable incomes than people who use Bittorrent.

Passive investors are free-riding on active investors. Granted, many other investors free-ride on one another—we all get liquidity from the quants, the quants avoid buying overpriced stocks because value investors arbitrage away big value discrepancies, and value investors avoid getting blindsided by macro shifts because macro investors make the appropriate bets.

But index investors don’t contribute to any of that. They’re just the world’s worst trend-chasers, combined with the world’s most counterproductive underwriters. If you’ve invested in index funds, please, please take a flyer on something on something specific—but only if you’ve thought about it first.

This post originally appeared at Byrne’s Blog.

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