We Come Not To Praise Indexing, But To…

 

 

Nicholas Colas is co-founder of DataTrek Research, an independent firm covering global finance and economics.  Colas is a 30+ year veteran of Wall Street, whose experience includes First Boston (now Credit Suisse), SAC Capital (reporting directly to Steve Cohen), and Convergex Group. 

His views on indexing are diametrically opposed to mine, but they are thoughtful and provocative. I hope his commentary provokes more debate on the topic.

 

 

 

 

Jack Bogle’s passing is a timely reason to spend a moment considering the growth of index-based investing, an approach he spent much of his professional life promoting with great success. Like many of you, we have watched indexing go from curiosity (in the 1980s) to limited acceptance (the 1990s) to widespread adoption (now). In terms of his impact on capital markets, Mr. Bogle has few peers in this or any century.

As far as what we can add to a discussion of index-based investing, we have three points to share with you today:

#1. Indexing’s rise – especially in US equity markets – over the past 20 years was not just a function of its low cost structure or notional simplicity.Rather, long run returns declined precipitously over the period. This left asset owners scrambling for ways to maintain equity exposure without paying active manager fees.

Some data to back this up:

  • Over the 20 years from 1980 to 1999, the S&P 500 compounded at an annual rate of 17.7%. If you had invested $100 at the start of this period, you would have come out the other end with $2,600.Now, if you paid an active manager 1-2%/year to invest in US equities over this period and they kept pace with the S&P, your returns would have been 5-11% lower than simply buying the index.
  • Over the 20 years from 1999 to 2018, the S&P only compounded at an annual rate of 5.6%. Instead of seeing $2,600 from a starting $100 investment (as with the prior point), at the end of 2018 you would only have $296.Paying an active manager 1-2%/year over the last 2 decades would have cut your returns by 18 – 36%. A good deal more than 5-11%, in other words.

The upshot here is that indexing didn’t damage the active management business (as critics often claim) as much as structurally lower US equity returns pushed asset owners to lower cost solutions like index funds. Mr. Bogle and other indexers caught this wave beautifully, but they did not create it.

#2. While the rise of “passive” indexing has caused increasing concern that it makes societal asset allocation less efficient, other “active” approaches to capital investment have grown dramatically as well. Consider:

  • McKinsey estimates the size of the global private equity business at +$5 trillion. Twenty years ago, of course, this was a cottage industry in comparison to now.
  • Buyout funds represent the largest slice of this pie, at $1.6 trillion, followed by real estate ($810 billion) and private debt ($637 billion).
  • The fastest growing piece of private equity is venture capital, which on a global basis put over $300 billion to work in over 30,000 companies just last year according to industry source Crunchbase.

This point has a tie to the prior one: as equity returns declined over the last 2 decades asset owners shifted capital to higher risk/higher return investments even as they embraced public equity indexing. If you’ve ever worked in a firm owned by private equity or venture capital, you know how “active” those owners can be.

The upshot: even with the rise of indexing, there is still a growing business for active management – it just isn’t in public equity markets.

#3. Future returns for US stocks will not be tied to how much capital is indexed, but rather the sorts of companies that come public in the coming years. Just look at the returns from the 2007 peak to now for the S&P 500 versus either the MSCI Emerging Markets or EAFE (Europe and Japan) indices to see why. US stocks are 69% higher, but Emerging Markets are down 26% and EAFE stocks are 28% lower.

The reason why US stocks have been wealth creators and foreign stocks have floundered: Amazon, Facebook, Apple and other tech names play a large role here, but so does the entire Health Care sector. Innovation at global scale drives returns, and not much else. Even the Chinese Tech giants have not been able to drive the Shanghai/Hong Kong markets to fresh post-2007 highs.

Summing up: to really understand how indexing has changed capitalism you need to look at the big picture. Its rise was a function of larger capital market trends, namely lower structural equity returns. Those in turn pushed capital to other, more profitable asset classes that solidly check the “active” management box even if indexing does not. As far as what the future brings, that is in the hands of the IPO calendar.