Vanguard Asks Has Indexing Gotten Too Big?

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A transcript of Vanguard’s Investment Commentary podcast series with Chris Philips on the growth of buying the market concept and if indexing has gotten too big. H/T Barry Ritholtz for the find.

Vanguard: Has Indexing Gotten Too Big?

Lauren Virostek: Hello, and welcome to Vanguard’s Investment Commentary podcast series. I’m Lauren Virostek. In this month’s episode, which we’re taping on August 19, 2014, we’re going to discuss indexing’s rise in popularity and why it’s raising some concerns in the investment community.

I’m here with Chris Philips, a senior investment analyst in Vanguard’s Investment Strategy Group. Welcome, Chris.

Chris Philips: Thanks for having me.

Lauren Virostek: Chris, the concept of buying the market has grown in recent years to the point where some believe that indexing is getting too big. But before we get to that, can you share your opinion on why indexing has grown so popular with investors?

Chris Philips: Sure. Indexing itself is getting a lot of publicity in the media. There’s been some well-documented challenges of active management, and the beneficiary of that has been indexing. The other wing of that has been the acceptance of indexing from financial advisors in terms of building out their clients’ portfolios.

So whether they’re actually looking for a core investment for their clients or looking to have more tactical satellites, if you will, indexing can play both those roles. I think the combination of strong performance or relative underperformance of active plus the acceptance as part of the core portfolio has really driven that interest in indexing.

Lauren Virostek: And how have ETFs contributed to the growth of indexing?

Chris Philips: ETFs themselves have really exploded in terms of the number and variety of ETFs out there. So think back 15 years ago: You couldn’t get a reasonable exposure to, say, global real estate or commodities. And now with ETFs, you have that access. You have easy penetration into a wide variety of markets and wide variety of strategies.

The growth of ETFs has really spurred this, and the ability of ETFs to deliver a particular benchmark at, hopefully, very low cost is really that other leg to this trajectory. And it is that new markets or traditional markets at very low cost, as well as the ease of use, which has really driven the rise of ETFs, as well as indexing.

Lauren Virostek: So if investors like the idea of indexing and it’s pushing the cost of investing lower, why do some believe that the concept is getting too big?

Chris Philips: Well, I think there’s always going to be questions out there whenever you see popularity of anything rising, because we know that nothing can grow forever. So we always hear that one company, whether it’s Apple Inc. (NASDAQ:AAPL) or Microsoft Corporation (NASDAQ:MSFT) or Exxon Mobil Corporation (NYSE:XOM), can’t grow to become the economy, or one country can’t grow to become the world.

Same thing: We get these similar questions about indexing. So it’s very easy to ask, “Well, what is the tipping point? Is there a tipping point for indexing, and should we be concerned by that? Are investors at some point going to be worse off with indexing relative to some other form of management?” But I think that really the genesis of some of these questions is, there’s been rapid growth, rapid acceptance, and it’s just natural for us to question these things.

Lauren Virostek: You’ve referred to investing as a zero-sum game in the past. Can you explain what you mean by this?

Chris Philips: Sure. The idea of a zero-sum game is actually pretty simple. It’s for every buyer, there’s a seller; for every winner, there’s a loser; and before costs, every investor’s invested dollar has to aggregate up to form a particular market. That in and of itself means that all the winning assets have to exactly equal or offset the losing assets.

Well, the idea of indexing is that you’re trying to get the average of all those assets at the lowest cost possible. So after costs, we know with bid-ask spreads, with frictions, with market impact, the taxes with management fees, that the process of active management, of picking stocks, picking bonds, managing those portfolios, is actually pretty expensive. After costs, the majority of dollars actually has to underperform the market. The beauty of indexing is that you can, therefore, outperform a majority of the higher-cost, actively managed dollars that are out there.

See full Vanguard: Has Indexing Gotten Too Big? in PDF format here.

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