(PUB) Investing 2015

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9 Morningstar FundInvestor May 2015
funds in the late 1990s 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
1 Sullivan, R.N., & Xiong, J.X. 2012. Financial Analysts Journal,
Vol. 68, No. 2, P. 70.