As passive investment strategies have continued to grow in popularity among investors, critics of index-based approaches have warned of hidden risks to the market. But a commentary from Vanguard analysts disputes those criticisms.
Some detractors have argued that index-based strategies have grown too big. But the passive-fund titan pointed out that based on the definition of indexing — constructing a fund to match or track the components of a market index — such strategies own just about 10% of the value of all global investable securities.
“At first glance, indexing’s growth might suggest a glut of portfolios performing in lockstep with the broad market,” the commentary continued. “But the average index fund investor hasn’t exactly tracked the broad market, bucking those expectations.”
As an example, the piece noted that from 1998 to 2016, the average returns seen by investors have varied from outperforming the Vanguard Total Stock Market Index Fund by 14% to underperforming it by 8%.
As for the idea that indexing raises market correlation and results in active underperformance, Vanguard performed an analysis of data from FactSet and Morningstar. The annual return dispersion of the Russell 3000 index remained fairly stable from 1993 to 2016, in spite of the growing market share of passive strategies over that time.
“Critics also express concerns about a relationship between indexing and higher market volatility, but the data tell a different story,” the firm continued. Another analysis of the FactSet and Morningstar data from 1993 to 2016 showed rising market share of index-based strategies, but the 12-month rolling standard deviation in the performance of the Russell 3000 seemed to rise and fall randomly, except during periods associated with the tech bubble and the great financial crisis.
Addressing the idea that more indexing activity leads to decreased price discovery, Vanguard pointed out that index strategies have low turnover and trade at the margin across a wide selection of securities, so their impact on trading activity is minimal.
“Portfolio management of indexing makes up about 5% of daily trading volume on US exchanges,” the firm said. “Other market participants, such as retail investors, high-frequency traders, and pension funds, account for the vast majority of trading volume. Active participants dominate securities trading and facilitate price discovery.”
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