By Andrew W. Alford, Quantitative Investment Strategies, Goldman Sachs Asset Management
Over the past several years, investment strategies that seek to match the return of an index – so called index investing – have experienced rapid growth, and for good reason.1 Conventional indexed strategies are simple, transparent, and low-cost. Yet steady investment flows into indexed portfolios – and the corresponding flows out of actively managed portfolios – has some market commentators worried that the ascent of indexing could be harmful to the economy and/or markets. We think these concerns are overblown, and below we give three reasons why.
One group of commentators questions whether index managers will fulfill their stewardship responsibilities to ensure that companies act in the best interests of their shareholders.2 After all, stewardship requires a lot of work. To the extent that index managers are evaluated primarily on their index-tracking ability, these managers may not feel motivated to thoroughly monitor a company’s management and/or board of directors. Moreover, given pressure to offer competitive fees, index managers may not have sufficient resources to develop detailed governance policies, review proxy statements, or engage with company management for all of the stocks in a typical index.
We find this perspective to be somewhat dated. While it may be true that index managers, in years past, put minimal emphasis on stewardship, that is no longer the case. As indexing has grown, so, too, have efforts by index managers to improve companies’ corporate governance.3 In our opinion, this makes sense: Indexers are the ultimate long-term investor. Active managers are free to sell a stock if they feel their position offers little upside, whereas index portfolios will generally hold a stock as long as it is part of the index, regardless of the company’s prospects.
Another group of commentators argues that indexing – either directly or indirectly – leads to reduced competition among the companies that make up an index.4 These critics point to the fact that index portfolios often hold a sizeable position in almost every stock in an industry, as they argue that index managers have little incentive to encourage a company to maximize profits if doing so would reduce the profits for other companies in the same industry.
This argument is also misplaced, in our view. The return of an indexed portfolio depends on the return of the underlying index, and not the return of one stock at the expense of another (as is often the case for an actively managed portfolio). Most broad-based equity indices comprise a wide cross-section of the stock market, and the performance of a broad-based index, like the equity market as a whole, is directly impacted by the performance of the economy generally. To the extent that vigorous competition helps promote economic growth, index managers (and their investors) have every incentive to encourage competition among index constituents.
A third group of commentators is concerned that the growth of indexing will hurt the economy by reducing market efficiency.5 Active managers determine the intrinsic value of each stock via in-depth fundamental analysis, and then help drive each stock’s price towards its intrinsic value through their trading decisions. As conventional active portfolios become a smaller and smaller fraction of all assets, some critics worry that the process for allocating capital will become less effective as fundamental analysis diminishes, as does the corresponding trading activity.
We agree that if indexing ever became the sole investing approach, it could diminish the information content of prices and thereby undermine the market’s ability to allocate capital. Active managers play an important role in helping to ensure that stock prices converge towards their intrinsic values.
But while indexing could be a problem in theory, we are not convinced that indexing poses a problem in practice, for three reasons. First, while the quantity of actively managed assets has been shrinking recently, we believe the quantity of actively managed assets provides an imperfect indication of the amount of active management. Not all active managers are the same. Some are more “active” than others. There is wide variation in investment styles across the population of active managers, from the strength of each manager’s conviction to the size of the coverage universe and the level of trading activity.
Second, a growing number of indexed portfolios reflect “active” views insofar as they pursue goals which are commonly associated with active management. Smart beta strategies that provide exposure to common equity factors are one example. These increasingly popular portfolios may be indexed, but that doesn’t mean that they are “passive” in the same way that market-weight indexing is passive. Third, many indexed portfolios are used to implement tactical (active) views within asset allocation strategies. Active investing still occurs, but via thematic portfolios and/or at the asset-class level rather than via individual stocks.
The risks of passive investing that we see today are instead at the level of the individual investor, namely the possibility that some investors will chase performance and buy the market indiscriminately. Active managers can help mitigate the risk of bubbles by exercising their discretion as fundamental investors, and helping to push stock prices back towards their intrinsic values. When coupled with active management, we view the rise of indexing as a largely healthy development, and we think the fears of indexing are largely misplaced.
Andrew W. Alford is a managing director on the Quantitative Investment Strategies team at Goldman Sachs Asset Management. For more views on smart beta, read Andrew’s “Indexing and the Evolution of Active Management."