“In a moment of decision, the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing.”
That quote is often attributed to Theodore “Teddy” Roosevelt. Like many internet quotes, scholars can find no record of him ever saying it, but it sure does sound like the man who gave us “The Man in the Arena,” the most famous stanza in his “Citizenship in a Republic” speech delivered in Paris in 1910.
Teddy passed away a little more than 50 years before the first “passive” index fund was created, but I feel confident that he would not have been a fan. The world is full of people who will tell investors they should invest is index funds because you can’t “beat the market.” There are, however, far fewer who can explain why that is supposedly the case.
The theory that spawned the index fund to begin with was explained in Eugene F. Fama’s 1970 paper, “Efficient Capital Markets: A Review of Theory and Empirical Work.” Fama argued that the market was “informationally efficient;” in other words, all available information is reflected in the current price of any asset (in our case stocks). In theory, the market price of a stock is always the “right” price; thus, no value can be added by choosing to invest in one stock over another. This efficient market theory then brought us the capital asset pricing model (CAPM). Every former finance student just had a shiver go down their spines at even the mention of it. CAPM is predicated on the assumption that markets are efficient and if trading were free, then the most efficient portfolio would be one that simply weighted stocks based on their capitalization. In plain English, an investor should invest only in the largest companies based on nothing but the fact that they are already big. Index investing was born. This is what the vast majority of index funds do.
The point of explaining the theory behind index investing is hopefully to drive home one simple idea that very few index investors have ever thought about: Indexing only works in an efficient market, but the market is made efficient by investors making independent active decisions based on the latest information available. Put simply, index investors are freeloading on the market created by active investors. It has worked for many years, but something has recently changed.
In their paper, “The Active Side of Indexing,” authors Rob Arnott and Lillian Wu outline the growth of index investing over the last 40 years. As recently as 2000, index funds held $0.4 trillion, or barely 3 percent of U.S. equities; as of December 2024, they now hold $13 trillion directly tracking the S&P 500 alone, which represents 21 percent of the value of the entire stock market and more than a quarter of the value of S&P 500 member stocks. In 2024, for the first time in history index fund assets surpassed those of active U.S. equity funds.
These numbers only scratch the surface. One thing the index investors get right is that the average money manager does not beat the market – after all, in a world without grade inflation, average is a C. Most of these average managers end up being closet indexers because they are afraid of ever trailing the index long enough to get fired. It is impossible to know exactly how many assets are managed this way, but it is a sizable number.
One thing index investors get wrong, which I pointed out in our latest The Quarterly Report newsletter and Arnott and Wu point out in their paper, is that they believe index investing is passive, when in fact it is not. The current turnover in the S&P 500 is approximately 15 percent, but Arnott and Wu use a much more conservative 5 percent. More important than the exact percentage is the index is weighted by capitalization, in other words the total value of the company. The companies being removed tend to be companies whose stock price has dropped, while the companies being added tend to be companies whose stock price has suddenly risen.
In addition, within the index, company weightings will change as some stocks rise and some fall. Every time an index fund gets new money invested, it has to then buy more of the stocks that have already risen and less of the stocks that have already fallen. Index investors are constantly buying high and selling low. This is active, but more precisely it is one particular active strategy: momentum investing.
The idea behind momentum investing is simple. Stocks have momentum, so when they are rising they will tend to keep rising, and when they are falling they will tend to keep falling. Of course, they do this until they don’t. At some point the stock price gets so high that no one will buy, and at some point, the price gets so ridiculously low that investors begin to buy. Momentum investing is therefore a short-term trading strategy, and it is very popular with traders.
Historically, momentum would be kept in check by active investors who would take advantage of the short-term momentum to take profits or buy good companies on the cheap. This is what makes a market – some investors buy while other sell, and vice versa.
As more and more of the long-term investors have moved to the index, we no longer have people on both sides of any trade. Snowflake, a technology company whose stock we own in our most aggressive strategy, recently reported earnings and the stock jumped 38 percent on that day. Through June 1 the stock was up 66 percent over the last three months, which makes it up 27 percent year to date; So, prior to jumping 66 percent, the stock had been down almost 40 percent…one cannot be a snowflake if she wants to invest in Snowflake (I apologize for the pun but couldn’t help myself).
The company itself is doing very well, but it did not grow business 38 percent in one day and business had not been down at all, let alone 40 percent, previously. The fact is that there was just no one on the other side of these trades. Anecdotally, we have heard this over and over again from mangers who historically would have “bought the dip” in a company like Snowflake, but now they are scared to do it. They are afraid to jump in because momentum is overwhelming fundamentals.
It is not just Snowflake. Intel – boring old, been-around-forever-Intel – jumped 23 percent on its most recent earnings. How does Intel jump 23 percent? There was no one willing to sell. When everyone is on the same side of every trade, then we no longer have a market. Real-world investors have been poking holes in efficient market theory and CAPM for as long as I have been in the business. Nothing was in either of those earnings reports that would change the value of those companies dramatically.
Thus far the ordinary investor has not noticed this enormous increase in volatility as it gets balanced out at the index level. The question is, how much longer will it be hidden? Will we see double-digit moves in one day for the index?
The market has always been irrational in the short run, and it has done a great job in the long run. Will that still be the case when no one participates, and everyone just tries to freeload? I don’t know the answer, but I strongly suspect Teddy Roosevelt would tell us to look to our inner American spirit and make a decision. At Iron Capital, we are going to continue to invest intentionally; we might just need a little more patience.
Warm regards,
Chuck Osborne, CFA
