Philosophical Economics: Index Investing Makes Markets, Economies More Efficient

The site Philosophical Economics recently published a challenge to the consensus idea that the explosive growth in U.S. equity index funds in unsustainable. The author argues instead that passive management over time increases the accuracy of market prices and reduces the opportunity for active managers to generate alpha.

The entire argument is based on two market principles. The first principle is the Law of Conservation of Alpha, which states that the aggregate performance of the active segment of the market will always equal the aggregate performance of the passive segment.

The second principle is the Efficient Market Hypothesis, which states that for a given group of securities, the market is efficient with respect to that group if all securities in the group are priced to offer the same expected risk-adjusted future returns.

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Philosophical Economics argues that, as more investors become passive, market prices will become more accurate because the small number of remaining active manages that set share prices will become a more and more skilled pool.

“How does passive investing increase the ‘average’ skill level of the active segment of the market? The answer: by removing lower-skilled participants, either by giving those participants a better option—i.e., the option of indexing—or nudging the wealth they’re ineptly managing into that option, putting them out of business,” the article concluded.

In other words, the market will continue to press all investors toward passive investing over time.

U.S. equity index funds have grown from a $500 million industry in the early 1980s to a $4 trillion market today.

Disclosure: The author holds no position in the stocks mentioned.