Are Index Funds Immoral?

29 March 2010 at 8:29 am 6 comments

| Lasse Lien |

If I had money to invest, which I don’t, I would probably invest via an index fund. I know just enough empirical finance to realize that beating an index fund is very difficult (impossible according to some) unless you are either very lucky or an inside trader. The reason is of course the efficient markets hypothesis. The stock market factors in all relevant information at lightning speed and without bias. However, this can only be so because there are enough investors that do not invest via index funds. If everyone did, the pricing would not be informative at all. One might argue that index fund investors are free riders on those that do fundamental analysis, and a sinister threat to the very market efficiency that they thrive on.

I guess in equilibrium one would expect index investing to increase until market pricing is so inefficient that the expected returns from it is driven down to around the levels of the best alternative.

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6 Comments Add your own

  • 1. David Gerard  |  29 March 2010 at 12:47 pm

    Excellent point. Maybe this emh stuff really is all made up. By telling everyone that they can’t beat the market so they should just buy index funds, it makes it easier for you to beat the market. It’s so obvious I’m surprised no one has thought of that before now.

  • 2. Agent Continuum  |  29 March 2010 at 1:00 pm

    Grossman and Stiglitz have some good work on this “paradox”: http://www.jstor.org/pss/1805228

    In equilibrium one has to be indifferent between being a passive and active trader, if all agents are the same. Your gains from being active should just cover the cost of being active.

  • 3. Lasse  |  30 March 2010 at 4:56 am

    David: According to Agent someone already has. Apparently I shared a thought with Grossman and Stiglitz. I demand a raise!

  • 4. srp  |  30 March 2010 at 7:59 pm

    Even if you don’t buy EMH, there is a pretty compelling argument for indexing: The total economic gains of the publicly traded sector are captured by the index. If you try to get more than that, you have to take it from someone who earns less than the index. In other words, beating the market is a zero-sum game while riding the market isn’t. (Of course all this has to be risk-adjusted, but the essential argument is the same.)

  • 5. Agent Continuum  |  30 March 2010 at 11:22 pm

    Well, maybe your skilled trading will improve the total value of the market ;-)

  • 6. ProfDC  |  31 March 2010 at 12:15 pm

    This is interesting, and I don’t think that the moral hazard aspect of this has been fully addressed by G&S. Remember, your action (of whether to invest actively or passively) is hidden. It seems quite similar to being a 2nd-mover free-riding on a 1st-mover’s R&D expenditure. When all traders are small and decide independently it won’t matter much, but it seems that a coalition of traders (e.g., the Bogleheads, who are each individually small but collectively command a lot of capital) could have a deleterious effect on the incentive to invest in price discovery.

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