Will Indexing Kill the Market?
The author seems to believe that indexing could actually be a factor in active fund underperformance. It's an interesting theory.
Up until now potential negatives from indexing were mostly academic observations. NYU professor Jeffrey Wurgler’s 2010 paper “On the Economic Consequences of Index-Linked Investing” summarizes nearly 40 studies about indexing that go back as far as 1986. He shows us quite convincingly how and why indexing has been affecting the market and its components for decades.
When a stock becomes part of an index its behavior changes instantly. “It is as if it has joined a new school of fish,” Wurgler writes. In summarizing the implication of all of these studies he turns the conventional wisdom about indexing on its head: “The popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average to beat the index; it may actually be contributing to their underperformance.” If Wurgler is even close to being right, our perception of indexing may be due for a major adjustment.
Some observers have suggested that indexing will never become large enough to pose a systemic threat to the market because there will always be enough investors to offset the mispricing that excessive indexing might produce. However, in the real world extreme behavior in markets is driven by powerful forces and rarely has a benign end. I’m reminded of the quote, often attributed to Lord Keynes, that “Markets can remain irrational longer than you can remain solvent.”
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