Indexing’s Biggest Myths

By Steve Tepper, CFP®, MBA


Talk to an active stock trader for a while, and they’ll tell you—well, I’m not positive what they’ll tell you. I avoid talking to active stock traders for a while, or any other length of time.

But if I did find myself in such unfortunate circumstances, and if I couldn’t resist the urge to proclaim my belief in efficient markets (and the fundamental principle that active trading is a losing endeavor), I am sure I’d be treated to a litany of evidence and theories (and perhaps an outright lie or two) in support of active trading.

And in building up their bona fides, these traders would attack the passive approach known as indexing, or buying funds that hold all of the stocks found in an underlying index (like the S&P 500) without making any judgment of which stocks are better than others.

While our investment approach at Northstar is a little more nuanced than a straight indexing approach, it is way closer to a passive strategy than an active one, and I would rather see any investor in a well-diversified, low-cost index fund than your typical high-cost active fund.

We’ve covered many of the hollow claims of the active managers in articles past, but here’s a recap, and a fun new one I don’t think we’ve discussed before:

  1. “You can’t beat the market with indexing.” While the claim that the purpose of indexing is to get, not beat, the market return is basically true, the conclusion that active investing is better is specious. Just because you can beat the market with active investing doesn’t mean you will. In fact, there is a much stronger possibility you will do worse than with a passive, index-based portfolio. And that’s mainly because of the falseness of Claim #2:

  2. “Good money managers beat the market.” It is also true that every year some fund managers beat the market. But we don’t know which ones until after they’ve done it, which in the absence of a Wayback Machine won’t help you. Active-management arguments to the contrary, we have no proven method of determining which managers will do well going forward. So the claim that some managers will beat the market is an empty one. It’s like claiming the million-dollar scratch-off is a good investment strategy because “some” of the cards are winners.

  3. “Active management can help you avoid losses in bear markets. Indexing can’t.” Another true but worthless claim. A big part of active management is market timing, getting in when markets are good and exiting when they turn bad. But there is no evidence that active managers are any good at this. Their attempts to time both their exit and reentry result in overall returns no better than, and often worse than, just riding the market ups and downs with a passive strategy.

  4. If everyone indexes, markets will become inefficient.” This one is my new favorite. A brief history lesson is needed to understand where it comes from. 

A Brief History Lesson

Despite their dominant control of the market and massive sales efforts, active managers have watched their market share slip over the past couple of decades. According to recent data from the Investment Company Institute, index funds grew from 15% of the mutual fund and ETF market in 2007 to 35% in 2017.

So now, with passive strategies on the rise, the active management misinformation machine has offered a new argument against indexing: It distorts market prices. Once again, they form the argument in a sound bite that seems logical: Active management sets proper market prices (equilibrium) as buyers and sellers come together to buy and sell their shares of stock. As more active market participants leave, the less efficient the markets will be at maintaining equilibrium pricing.

Like other arguments against indexing, it looks good on paper, but it isn’t supported by real-world evidence.

Longtime research partners Kenneth French and Nobel Prize Economist Eugene Fama recently pointed out that the large outflow from active investing might easily be a good thing for establishing proper pricing in stocks: “If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of pricing improves.”

Of course! And who is more likely to be exiting the active marketplace? Well-informed investors who are successful at the task or poorly informed actors who exit out of frustration of their dismal performance? The less efficient traders are, the less efficiency they are adding to the market, and the less they will be missed if they leave it.

But how many participants can leave the market? Don’t we need a lot of trading activity to set prices to their proper equilibrium level? French and Fama continue: “The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.”

Clearly, Fama and French believe markets can maintain efficiency even if a substantial percentage of active trading stops. And we’ll look at some evidence of that in a minute.

Another problem with the anti-indexing argument is that it ignores other market activity through which prices are set and reset as new information becomes available. Companies issue stock shares (such as IPOs) and repurchase shares (buybacks). Buyers of newly issued shares and sellers of buyback shares can be both active and passive investors. Derivatives markets also see trading of hundreds of millions of dollars of stock options and futures. Again, not all of those traders are active investors. Some investors buy futures as hedges or to cover another position. All of that activity helps set proper stock prices.

My favorite counterargument against the claim of inefficient markets is so obvious it’s a wonder the active world ever dared to suggest the claim in the first place. If markets are becoming more inefficient, then why aren’t active managers doing a better job of beating the market? Really, isn’t that exactly what they are supposed to do? Find market inefficiencies and exploit them? Find improperly priced securities, buy the undervalued ones, and sell the overvalued ones?

As passive market share has skyrocketed over the last decade, we’ve seen the same trend from active managers: Very few of them beat the market return after costs.

In the end, that makes any other claim they offer meaningless. What if we reach a point when indexing does impact price equilibrium? Active managers still have to prove they can take advantage of it and deliver better returns. Until then, I’m not changing my strategy, and I don’t see myself recommending that any of my clients change theirs either.


The Index Bogeyman from Dimensional Fund Advisors, April 2019