paradox of thrift; paradox of indexing?

The paradox of thrift is the idea that the common sensical approach individuals take in bad economic times–that is, to save a lot more–actually reduces overall consumption and ends up making a bad situation worse.

 

People are beginning to talk about the same sort of situation happening with investing and index funds.

The idea of indexing was initially popularized by Charles Ellis, who argued that large numbers of well-trained, well-educated, highly motivated, highly compensated portfolio managers were battling it out with one another every day in the active management world.  Therefore, he argued, none would be able to maintain a clear competitive advantage over any of the others.  And they would all be running up costs in their (futile) attempts to do so.  Therefore, the wisest course for anyone would be to take the lowest-cost route–simply buying the index.

Of course, it took Vanguard to provide the means and many years for the idea to be accepted.

Today, in contrast, it’s accepted that the lowest risk course of action, and likely the highest return one as well, is to buy an index ETF or mutual fund.

Over recent years, there has been a steady flow of assets away from traditional active managers in the US and into index products–meaning less money from management fees to fund active manager research.  In addition, the recent recession has triggered the mass layoff of seasoned brokerage house equity analysts.  (This is due to the contraction in assets under active management, regulatory constraints on the use of “soft dollar” commissions and the dominance of trading over research in brokerage firm office politics.)

Are we at the point where indexing has culled the herd of active managers enough that the fierce competition which has made the US stock market super efficient over the past generation is no longer functioning?

No, not yet.  2014 was the worst year in a long time for active managers, as far as outperformance is concerned.  And we know that hedge funds have rarely been able to keep up with the S&P.

However, today’s Wall Street seems to me to be much more reactive than proactive when it comes to company news.  That is to say, the market seems to react more strongly to company announcements of good or bad news, rather to have anticipated them from leading indicators.  Take, for example, the shock Wall Street showed when firms had weak 4Q14 results because of euro weakness–even though the size of the firms’ EU business was well-known and the change in value of the euro is shown in currency trading every day.

So something has changed.  It may simply be that brokerage research departments were much more important to the smooth functioning of the equity market than has been commonly perceived.

My question:  will individual investors take the place of active managers in keeping markets efficient?

 

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