The Case for Diversification in the Age of the Index Fund

Image – Katrina Tuliao
Article reviewed by an anonymous teacher at Farmingdale High School

Most investors have likely heard the term “time in the markets is a more reliable way to preserve and grow your wealth than timing the markets,” a philosophy shared by many of the most famous investors of our time such as Warren Buffett and Ken Fisher. This statement ultimately reflects a wider market observation: most investors can’t beat the S&P 500 (an index tracking the 500 largest companies in America) in the long-term. This raises questions for many unfamiliar with financial theory. Is this true, and if so, why is this the case?

To better understand both if and why this is the case, we can explore one of the foundational theories behind modern finance. According to The Efficient Market Hypothesis and Its Critics (2003) by Burton G. Malkiel of Princeton University, the efficient market hypothesis was widely accepted a generation ago, which is the belief that the stock market is extremely efficient in reflecting information about both individual stocks and the market as a whole. Malkiel explains the hypothesis as the ability for the markets to rapidly spread news and incorporate it into the price of stocks, with little delay. As a result, neither technical analysis, which studies the past performance of a stock, nor fundamental analysis, which studies company financials, would enable investors to achieve returns that would be greater than if they held a randomly selected portfolio made up of individual stocks with comparable risk to the indices. Malkiel says that by the turn of the century, intellectual acceptance of the efficient market hypothesis had become less universal, wherein many financial economists and statisticians started to believe in partial predictability of stock prices.

Malkiel decided to put the efficient market hypothesis to the test, believing that the “most direct and convincing” tests of it would be to directly test professional fund managers’ ability to outperform the broader market. He theorized that if market prices were determined by irrational investors, differed from rational estimates of a company’s value at a systematic level, and if it were easy to spot any predictability in the patterns of stock returns and prices, then those fund managers should be able to beat the broader market. He also believed that the fact that these professionals were often incentivized to outperform the market would contribute to their performance being compelling evidence of the hypothesis.

Malkiel found “remarkably large” amounts of evidence suggesting that professional investment managers are not able to outperform index funds. “The first study of mutual fund performance was undertaken by [Michael C. Jensen] in 1969. He found that active mutual fund managers were unable to add value and, in fact, tended to underperform the market by approximately the amount of their added expenses.” He repeated Jensen’s study with newer data in 1995 and confirmed the earlier results of Jensen. Furthermore, he found that many poorly performing funds merged into other funds to bury the records of underperformance, what he calls “survivorship bias data.” According to Malkiel, that survivorship bias makes interpreting long-term datasets for mutual funds incredibly difficult. In fact, even when using datasets containing survivorship bias, it is still not feasible to argue that professional investors can beat the market. He showed that at the time, for the previous three decades, about 3/4 of actively managed mutual funds have been outperformed by the S&P 500 and the Wilshire stock indexes, obtaining similar results for earlier decades, as well as noting that the median professionally-managed large market cap equity fund has underperformed compared to the S&P 500 by almost 2 percentage points for time periods ranging across the past 10, 15, and 20 years as of the time this paper was written. Similar results have also been shown in different markets against different benchmarks. Malkiel says that despite having equivalent risk, managed funds often underperform broad index funds. The funds that do outperform in one period are unlikely to continue that trend through the next, concluding that there is no dependable persistence in their performance.

However, the very success of indices in comparison to fund managers as seen in tests of the efficient market hypothesis introduces our next question: what are the implications of increasing investment in index funds? According to Passive in Name Only: Delegated Management and “Index” Investing (2018) by Adriana Z. Robertson of the University of Toronto, it is a misunderstanding to say stock market indices are “passive.” Robertson says there is a vast amount of diversity among the different indices, even in those that claim to have similar aims as one another. In fact, they are far from passive, often representing deliberate decisions of their fund managers, and the implications of this system are far-reaching.

According to Robertson, index investing has taken on an “increasingly important role in recent years,” citing a report published by the Bank for International Settlements which found that as of June 2017, passive funds managed about 20% of aggregate investment fund assets, a substantial increase from 8% one decade earlier. In particular, that rise has been concentrated in American equity assets, where passive funds account for 43% of total American equity fund assets. Robertson says the widespread implications of the rise of index-linked investments on the broader financial markets have been the subject of substantial academic research, one branch focused on the anticompetitive effects of common ownership driven by institutional investors and indices as well as the potential solutions to this problem. Another branch emphasized concerns about how index-linked investing could affect corporate behavior, investment, and thereby impacting the broader financial markets. Robertson cites the work of Lucian A. Bebchuk and his coauthors in The Agency Problems of Institutional Investors (2017) where governance concerns as a result of index and passive investment are highlighted alongside the positive impacts and facilitation of investor activism. Other concerns include the implications of index-linked investing on efficiency and liquidity (how easily transferrable an asset is to cash), where there were mixed results. Robertson says that the fact that investment in indices is “simply another form of delegated management” is overlooked.

Robertson does note that there is “nothing inherently wrong with delegated management.” Despite scholarly concerns about corporate governance implications, the ability to delegate management of a portfolio is helpful because having a well-diversified portfolio is offered by many portfolio managers. These portfolios have far less risk than the concentrated portfolios often seen with individual investors, and many individual investors often exhibit patterns and behaviors that “systematically reduce the returns on their investments,” which Robertson says can be avoided by delegating management of their investments to portfolio managers.

Furthermore, the type of delegated management that is being used when investing in indices is potentially better for investors than other types of delegated management such as actively managed mutual funds because index funds tend to have far lower management fees, and as a result, often offer superior returns to investors. “The point is not that there is anything wrong with the delegated management implied by an index fund, only that it is still delegated management” says Robertson.

While beneficial to many individuals and institutions, there are broader economic consequences of a shift to investment in indices that must be addressed. According to On the Economic Consequences of Index-linked Investing (2010) by Jeffrey Wurgler of New York University, the economic effects of mass investment in indices stem from the limited ability of the stock market to absorb what he calls “index-shaped demands” for each of the individual securities within the indices. Wurgler says that the increasing popularity of index-linked investing could actually reduce its ability to deliver its “advertised benefits” while exacerbating and increasing its broader economic impacts at the same time. So what exactly are these economic impacts? According to Wurgler, while it is not possible to determine the exact dollar amount of American equities that are tied to indices, that amount is estimated to be in the trillions of dollars. What this means for the market is that every trading day, billions of dollars in cash flow affect all of the companies that are members of the indices, while this large-scale cash flow movement doesn’t affect the non-members. This certainly impacts the prices of the members’ share prices on market, and as a result, investor reaction to price movements of indices sometimes require a change in exposure to those same indices, potentially creating a feedback loop where “shocks to prices lead to further demand, further shocks to prices, and further economic consequences. These cycles can operate at frequencies of both years and seconds.” Wurgler says that every economic decision that depends on stock prices is thereby distorted by what he calls “mispricing.”

Notably, there is an impactful link between the stock market and corporate investment policy. In particular, much of the impact of stock prices in direct correlation to investment policy is through the calculation of market betas (a measure of risk) to be used as inputs to a Capital Asset Pricing Model (CAPM), which was found in a survey to be used by 73.5% of Chief Financial Officers in capital budgeting. For the individual companies listed on the indices, Wurgler says that the average stock added to the S&P 500 sees a beta increase by +0.10, which in turn increases the cost of equity as an output value of CAPM. Another impact of this difference in cost of equity can be seen in credit scoring models such as Moody’s KMV, the Merton model, and Altman’s Z-score, where greater equity value implies a greater distance to debt defaults. Once again, this affects corporate investment in that debt financing, especially for large companies such as those listed on the S&P 500, is typically more important than equity, creating a price premium on these stocks. Again, this affects corporate investment policy in that stock prices are often seen as a proxy for the profitability of investment.

Furthermore, according to Wurgler, indices such as the S&P 500 are becoming increasingly detached, representing shrinking amounts of the performance of the full stock market in comparison to more comprehensive indices, such as those based on the Wilshire 5000, which he says now provide more robust diversification and stock market exposure.

Given the implications of the efficient market hypothesis and the economic impacts of index investing, how should investors approach portfolio strategy? While academics have universally recognized the benefits of index investing, understanding the discussed implications allows us to realize that in most cases, it is more meaningful to follow a broader, diversification-based strategy, including a mix of indices, low-risk assets, and higher-risk assets. According to Edward Jones Investments, owning a well-diversified portfolio is both less risky and has historically increased chances of positive returns due to reduced volatility. Although well-diversified portfolios may seem to “lag behind” in times of rapid growth, they also assume far less risk. In fact, according to AllianceBernstein, less volatile stocks tend to outperform indices over the long-term. Because these less volatile stocks are not as heavily impacted by “booms and busts,” they do not have to make as much back after a crash to properly recover. Compounded over full market cycles, these gains are substantial. This is of course an interesting phenomenon defying the traditional logic of the “risk curve,” where there is a positive association between risk and potential returns. Despite this, AllianceBernstein cites academic research confirming the anomaly has been visible for much of the past century.

Widespread investment in indices represents a fundamental shift in modern finance. While the economic impacts and systemic risks of such mass investments in indices are significant, their demonstrated ability to consistently outperform fund managers over the long-term remains an undeniable reality. An overwhelming amount of evidence has pointed both risk-averse institutional and personal investors to a nuanced, but strong strategy as a synthesis of what we understand about equity markets; that being, the strongest strategy seems to be a combination of multiple different indices as the core of a well-diversified portfolio across varying asset classes and risk exposures, leveraging the benefits whilst mitigating the risks of overconcentration in each asset class. When properly utilized, diversification can be incredibly powerful.

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