looks like. Your 80-year-old uncle Bernie started investing when he was 18.
Anytime he had some extra cash, he
bought some shares of mostly blue chip
companies, took the certificates and put
them in his safe deposit box, where they
remained untouched for decades. Uncle
Bernie is now living on the dividends and
his shares will be passed on to his heirs
when he dies. That is passive investing.
In the early years of the advent of
indexed mutual funds, one could legitimately claim that indexing, while perhaps
not totally passive, was benign enough
to be somewhere in the “passive adjacent” neighborhood. But the immense
popularity of ETFs lured indexing away
from that neighborhood a while ago.
“Indexing is not part of the price setting mechanism of the market”: Market
prices are set by one thing and one
thing only: supply and demand. The aggregate behavior of all market participants creates supply and demand—and
therefore sets prices.
Healthy markets—efficient markets—are driven by participants who
act independently from each other, and
whose diversity of opinion, strategy,
knowledge and wealth come together
to form the foundation of a truly remarkable and beneficial enterprise. Of
course, markets are not perfect and
periodically market participants will
start acting in concert with one another—reducing market efficiency and
health. The most famous examples of
this are speculative bubbles and their
aftermath. But as we are now witnessing, speculation (or panic) is not the
only reason for investors to act as one.
It doesn’t matter what is driving
the supply and demand for securi-
ties: It could be fundamental research,
bottom-up valuation, top-down mac-
roeconomics, technical analysis, mo-
mentum, astrology—or more lately and
more frequently, funds that make their
purchase and sale decisions in order to
match an index. The most important
factor in supply and demand (price-
setting) is size. The bigger you are, the
more money you have, the more that
your trading behavior will influence
supply and demand.
The big stick in the market is in-
creasingly being swung by index-shaped
securities. The latest estimates suggest
that about 30% of all U.S. equities are
indexed. Even if index funds were not
truly passive, if their only use was by long-
term investors, one would expect that
their impact on daily trading would be
minimal, in the low single digits for sure.
That is not what is happening. Ac-
cording to data from the NYSE Eu-
ronext, exchange-traded funds (ETFs)
accounted for 27% of all trading volume
in all U.S. markets during 2013. Yet
despite overwhelming evidence to the
contrary, the fantasy persists that index-
ing doesn’t affect supply and demand.
“Indexing can never become too popular
because there will always be enough active
investors to keep the market efficient”: This
is indexing’s Get Out of Jail Free card—
a clever piece of self-deception built on
just enough logic to sound reasonable.
Financial markets are self-correcting;
that is one of their enduring strengths.
But anyone with even a cursory un-
derstanding of market history knows
that markets can remain inefficient for
challengingly long periods and the ulti-
mate self-correction, when it happens,
is rarely if ever a benign affair.
When inefficiencies of pricing are
the result of too many investors with
deeply entrenched convictions controlling too much money, those inefficiencies are almost impossible to exploit.
Smart investors are not going to waste
their time trying to pick up nickels in
front of a multi trillion dollar indexing steamroller. They are keenly aware
of the observation, often attributed to
Lord Keynes that, “Markets can remain irrational longer than you can
I’m sure that Lewis Ranieri had no idea
that the plain vanilla mortgage securities he created in the late 1970s would
turn into the convoluted, leveraged
and opaque instruments that nearly
brought down the financial system in
2008. And I’m equally certain that indexing’s godfather, John Bogle, never
anticipated the seemingly unlimited
uses institutional investors appear to
be finding for indexed ETFs and the
not yet actualized risks those growing
If the market activity coming from
indexing-shaped sources continues
to increase, the drivers of supply and
demand will continue to narrow and
the market will continue to grow less
efficient. How and when the ultimate
risks of that combination actualize
is impossible to predict. But when
enough investors start to suspend rational thinking in order to justify an
investment strategy, it’s certainly worth
a few moments of our time to consider
Investing is not challenging because it is hard to see into the future.
Investing is challenging because it is
often hard to accept what is so easy to
see in the present.
Marshall Jaffe is managing partner of
Jaffe Asset Management, an investment
advisory firm in Beverly Hills, Calif.