(PUB) Investing 2015

May 2015

Morningstar FundInvestor

9

funds in the late 1990 s and subsequent stock market woes, one can’t do the same for the 2008 crash. Index funds took in more cash in 2008 than they did during the previous year, and more cash yet the following year. In other words, index funds appeared to be supporting the market during its decline, not harming it. Whatever factors are to blame for 2008 ’s plummet, index investors would not seem to be one of them. In short, there has been a lot more behind Vanguard’s sales success than the accident of a blue-chip bull market. Among the reasons are discount pricing, clear communications, a cautious fund-launch approach, and unusually strict invest- ment-risk controls. As a result of these practices, Vanguard has developed a reputation as a fund manager that takes unusually good care of its share- holders and that delivers on its promises. It is these attributes, not the providence of a given market sector, that have propelled the company to the top of the charts. The second answer is anything but straightforward. Active managers like to talk about how the growth in cap-weighted indexes helps them by reducing competition. It’s a compelling argument. Last year, this column discussed an academic paper that measured how much more difficult investing has become over the past 30 years because of the increase in professional active management. By the same logic, investing should become easier as indexing squeezes out active management. It’s not quite that simple. The percentage of the stock market that is held passively has certainly risen— but stock prices aren’t set by those who merely hold. Prices are set by buyers and sellers, many of whom continue to be active investors. Also, index funds would prefer to be price-takers than price-makers, meaning that they wish for less-patient active managers to push stock prices around, then buy or sell against the market trend. In practice, though, index-fund managers may end up driving stock prices more than they would like. Yes, Vanguard’s index managers try to trade against the market when possible. But their first task is to put their cash inflows to work so their funds precisely

track their benchmarks. (Some index-fund managers are willing to accept more tracking error in exchange for making fewer trades, but Vanguard prides itself on having its index funds hug the benchmarks as closely as possible.) Thus, in practice, the role of price-taker is largely filled by value investors, with growth inves- tors making the stock prices and index funds landing somewhere in the middle. In theory, that still wouldn’t make the rise of indexers destabilizing. After all, if there’s a bubble in U.S. stocks, that bubble is presumably created by the volume of the inflows, rather than the method of investing. If indexers did not exist, surely other parties would invest the inflows and push up asset prices. Right? Or so it would seem. But a 2012 Financial Analysts Journal paper by Rodney Sullivan and Morningstar’s own James Xiong 1 raises a warning flag about spillover effects with market-cap indexing. In the words of the authors, the growth in market-cap indexing has led to “increased volatility” and “market- place fragility.” That case is far from proven, as the authors themselves acknowledge; it’s a difficult task indeed to extract cause from effect in explaining recent stock market behavior. (Vanguard, unsurpris- ingly, disputes the authors’ hypothesis.) But it must be acknowledged to be a possibility. It’s Not Over Yet The headline “What Happens When Vanguard Owns Everything?” is of course a cheat; Vanguard will never literally own the whole stock market. Nor, I suspect, will it ever have even a bare majority. But the notion that Vanguard in specific and indexing in general have grown too large has become quite common. I think those concerns are overblown. Vanguard’s situation is different from that of the industry leaders before it, and while indexing may eventually undercut itself through its own success, that time has not yet arrived. Even if indexing is destabilizing the market, it’s not clear at all that active managers can profit from that knowledge. K Contact John Rekenthaler at john.rekenthaler@morningstar.com

1 Sullivan, R.N., & Xiong, J.X. 2012. Financial Analysts Journal , Vol. 68, No. 2, P. 70.