Recently I started reading Seth Klarman’s book ‘Margin Of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor‘. Although the book came out in 1991 it is still a very interesting read. To me the paragraph about index investing stood out. Indexing is the practice of buying all the components of a market index, such as the Standard & Poor’s 500 Index, in proportion to the weightings of the index and then passively holding them. This comes from the believe that financial markets are efficient and that all information is reflected in stock prices instantaneously. According to this theory it’s almost impossible to outperform the market, something value investors, who believe in inefficient markets, disagree with. I always thought that index investing was a more recent phenomenon popularized by ETFs (exchange-traded funds) since the mid ’90s but apparently it was already popular in the ’80s.
Since index investing is widely popular right now it is nice to hear a critical note against it. Even Warren Buffet recommended index investing in his latest letter to shareholders. Below is a summary of what Seth had to say about it in his book (pages 40-42). He was not really positive about index investing (he even called the paragraph “Index Funds: The Trend Toward Mindless Investing”) and thought it was a fad that would eventually disappear. The reasons he gives are:
- An index fund manager never buys or sells shares when they hit an attractive value and index fund managers are not interested in the financial statements of the companies they invest in. Furthermore, they don’t even need to know which business the companies they invest are in.
- The higher the percentage of investors who index the more inefficient markets become. Fewer and fewer investors would be performing research and fundamental analysis. In extreme circumstances, when everyone would index, stock prices would never change relative to each other because no one would be left to move them.
- When a stock in the index needs to be replaced, either because of a take-over or a bankruptcy, index funds will buy the new stock that is getting into the index regardless of whether or not it is a good buy. Since 100’s of funds need to buy the same stock on the same day, a liquidity problem could send the price of the stock higher simply for the reason that index funds need to have it in their fund.
- Liquidity is also a concern with small-cap stocks. More money flowing into small-cap index funds will push the prices of these stocks higher simply because there is less liquidity in these markets. It will also push the price down more in a bear market because of huge sell orders.
- The index fund manager has no interest in the performance of the index, other than that fees are based on total managed assets valued at market prices. So the index fund manager wouldn’t be very interested in going to share holder meetings and educate himself on the best outcome for the investors he represents.
- There is a self-reinforcing feedback loop created whereby the success of index investing leads to more people swarming to index funds which leads to more success for the index. When that trend reverses, matching the market won’t be that attractive according to Seth Klarman, the selling will then work the other way around and depress the price of the index.
Seth Klarman also uses a quote from Warren Buffet on index funds to further make his point: “In any sort of a contest – financial, mental or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try”. Which is none the least interesting because Warren Buffet has been advising his trustee to put 90% of his money in index funds in his Berkshire 2013 letter.