Indexing’s Looming “Free Rider” Problem

“If you’ve been playing poker for a half-hour, and you don’t know who the patsy at the table is . . . it’s you.”

–Warren Buffett

“Index funds run by Vanguard see record inflows as savers turn to autopilot.”

–“Investors Shun Stock Pickers”; The WSJ (1/5/2015)

I’m a long-time fan of passive, index investing, for a host of reasons.

Such funds have ultra-low costs.

They out-perform the vast majority of actively managed funds (see, “Reason #1”).

And they save investors the headache and time of researching stocks (or advisors who select them), to decide where to put at least a chunk of their retirement nest eggs.

Tail Wagging Dog

So, what’s the one drawback?

Theoretically, at some future point, index funds could become so popular that they undermine the price-setting mechanism that makes markets, well, markets.

As one commentator asks:

“With index funds accounting for so much of new investment, how soon will it be before they become so dominant that effectively no one is setting prices for stocks beyond a minority of active managers, day traders, computer algorithms and investment bank proprietary trading desks? That could mean prices being determined even more by momentum and less by intrinsic value based on economic and corporate fundamentals.”

–Conrad de Aenlle, “How Index Funds Mislead Investors“; MarketWatch (12/30/14).

Fewer Chickens to Pluck?

Personally, I don’t worry about that, for two reasons:

One.  That point is far in the future.

In fact, as the “dumb money” realizes that it can do better simply piggybacking on market returns, the field is left to the most sophisticated, price-setting investors.

Two. The vast majority of arguments I’ve seen disparaging indexing are made precisely by such sophisticated (shark-like?) investors.

Which makes sense:  if I were the most sophisticated player at the table, the last thing I’d want is for the “patsies” to drop out.

About the author

Ross Kaplan has 19+ years experience selling real estate all over the Twin Cities. He is also a 12-time consecutive "Super Real Estate Agent," as determined by Mpls. - St. Paul Magazine and Twin Cities Business Magazine. Prior to becoming a Realtor, Ross was an attorney (corporate law), CPA, and entrepreneur. He holds an economics degree from Stanford.

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