One Pro Explains Why The ‘Indexing Will Kill Us All’ Crowd Is Wrong

[Editor’s note: As many readers are likely aware, fan-favorite Kevin Muir — formerly head of equity derivatives at RBC Dominion and better known for his exploits as “The Macro Tourist” —  this year transitioned his daily letter to a subscriber-only format. On Monday, I asked permission to republish one of his latest missives, which he granted on a one-off basis. The following is available exclusively to his subscribers and mine.]

Tell me the last podcast or research report that really turned your crank. You know, something that made you instantly send it to your trading pals with a big CHECK OUT THE ATTACHED message.

My bet? It was a bear argument.

Or if it wasn’t a bear argument, it was something that will benefit when the world goes off the rails (i.e., gold).

Now you might tell yourself that this is the result of the unique circumstances we are in, but I have news for you – our brains are hardwired to find these arguments more attractive. If it wasn’t COVID, it was the Great Financial Crisis. If it wasn’t the GFC, it was the DotCom bubble. If it wasn’t that bubble, it was the 1987 equity crash. There is always some great disaster lurking around every corner and we are just one catalyst away from it all collapsing inward.

I get it. I suffer from it as well.

But after many years in the market, I am learning on how to deal with this affliction.

Now, don’t think that I am some blind bull that only knows what blue tickets look like.

I am not trying to say that you should always be long, but that you should be careful when you hear a great sounding bear argument from what is often a hedgie who is already pedal-to-the-metal short.

The other day I got the same “CHECK OUT THE ATTACHED” message from different buddies. Although they are prone to the dark side, this time they seemed particularly enthused about a tremendous short side opportunity. I knew I was in for some serious bear porn (please don’t Google that, it has a completely different meaning outside the financial industry).

So, I checked it out. It was Grant Williams’ podcast called The Endgame and he was interviewing Mike Green.

Now, before we begin, I want to say a couple of things.

First, this is a terrific podcast. Absolutely top notch, and if you get nothing else from this post, I hope you put it on your listening list. Grant does a tremendous job interviewing a wide-ranging suite of guests and we are all infinitely better off from it. We all owe Grant Williams, Bill Fleckenstein and all the guests that appear on the show a big thank you.

Second, Mike Green is a masterful presenter. His bear arguments are persuasive, slick and oh, so very tempting.

I have nothing but respect for anyone who puts themselves out there, and I present the following rebuttal, not because I am certain Mike is wrong, but merely because I’m worried this is one of those cases that sounds exciting, but really, we should just put the Porsche back in the garage.

The evils of indexing

I won’t spend the time repeating Mike’s argument about the problems with the increasing move to passive investing, instead I am borrowing the synopsis of his interview with Real Vision:

Green argues that the simple algorithmic logic of passive vehicles causes irrational capital allocation. He asserts that these passive strategies only make money in a liquidity-enhanced environment, and he explains that stresses to the indices’ lack of cash reserves could create market volatility. Green and Pal examine the shift to passive vehicles and how that shift is molding the fate of both baby-boomer pensioners and millennials.

I am sure you have all heard some form of this argument. Often the increasing market weight of the top capitalized stocks is cited as an example of how the world has gone haywire.

The always insightful Sentimentrader’s recent tweet sums up the worries from the bears:

Usually this is followed up with some sort of graph showing the massively-stretched weighting versus previous periods:

The bears argue this is a perverse unnatural consequence of the perils of indexing, and use these charts to warn about the coming collapse when this liquidity fueled madness ends.

What you might notice when you see these charts is that they always start in the 1990s. Why is that?

Well, because this is what a longer-dated chart looks like:

Pretty sure there was little indexing in the 1970s, yet the market cap of the top five names was higher back then.

So, there is my first complaint about this “indexing will kill us all” argument.

Why do hedgies assume everyone else is wrong?

At this point you might be saying, “well, just because concentrations used to be higher, that doesn’t make Mike’s arguments wrong.”

Yeah, maybe. And listen, I don’t have fancy scholarly papers to cite. My opinion regarding most academic papers is that they all have one important flaw – they are written by folks who have never traded. Too often, they just don’t understand how the real world works.

So here is my problem with Mike’s argument that indexing is distorting the markets – he has assumed that free markets don’t work, and that somehow millions of people choosing their form of equity exposure are wrong.

Here is a thought. What is the collective choice of all those individuals is actually correct?

What if the reason they are choosing index products is because they realize, on the whole, active management is not worth it?

According to a Barron’s article, only 29% of active managers beat their benchmarks in 2019. So why is the market “irrational” for allocating more capital to this strategy?

Ok, I know the pushback. The only reason that active managers can’t beat the market is because the distortions from the already-over-priced top weighted stocks only gets worse as more and more money flows into passive accounts. Yeah, I get it. But why is this any different than in the 1970s when money pushed up the price of the Nifty Fifty? Or in the 1990s when capital flowed into the DotCom stocks? In both of those instances, money was chasing the hot sectors and made those stocks stupidly overpriced. If you didn’t own them as an active manager, you were crushed and also dramatically underperformed the index. You could argue that at least this time in 2020, the highest weighted stocks are actually making the bulk of the profits.

But what I think is funny, is that the “indexing will kill us” crowd assumes that markets are not at all self-correcting.

Let me get this straight; you believe in markets and think they are the best way for capital to be allocated, yet you at the same time believe investors’ choices to be wrong? All those people choosing indexing just don’t know what’s best for themselves? And the collective decisions of all those individuals don’t result in the best allocation of capital?

At this point, you will probably recall all the times the market got big stuff wrong. Dot-com stocks in the 1990s, real estate in the 2000s, you name it – I won’t push back on whatever you cite as an example of how stupid the market can be. Don’t forget, I make my living finding market inefficiencies, so I am fully aware that they exist.

However, I genuinely believe that over the long run, the market figures it out. Call me a Graham disciple if you will.

In the short run, the market is like a voting machine. But in the long run, the market is like a weighing machine.

I have never heard Mike Green’s response to this counter-argument, but it’s probably safe to assume that he would argue that eventually the market will figure it out, but by then it will be too late and the indexing bubble will have burst, bringing down all of finance with it (my imagination might be running away a little, but hey – bear porn and all that).

This bear crowd would most likely argue there are no self-correcting mechanisms to change the flow from indexing to active.

I call bullsh*t on that one.

The moment that active managers outperform indexing, clients will flock to the new strategy.

So the real question is, can this happen without some cataclysmic event?

Mike argued that at its extreme, indexing will cause stocks to be infinite bid, and then when the final active manager is gone, there will be no bid and stocks will literally go to zero (or the government would be forced to buy them).

Here is an alternative idea.

As indexed stocks become more and more valuable versus non-indexed companies, it becomes advantageous for expensive companies to buy the inexpensive in takeovers. If a company is trading at 20 times sales because it is in the index, and a smaller competitor is trading at 5 times sales, why not buy that smaller competitor at 10 times sales and arbitrage the difference?

And then, if this starts to happen, how long do you think passive will outperform active? I think these sorts of events would make it much easier for active managers to outperform.

Mike is correct that there is likely no self-correcting mechanism on the part of investors’ flows to stop the monster trend into passive. They will keep doing that as long as it continues to work.

However, Mike is assuming all this happens in a vacuum and the constituent companies do not change their behaviour.

Not only that, think about how difficult it gets for index companies to continue to appreciate. If an index company trades at 30 times earnings, to get a price double from P/E expansion, you would need a doubling to 60 times earnings. Then think about the down and forgotten non-index stock that is trading at 2 times earnings. To get a double, you only need it to go to 4 times earnings. What takes less capital to occur?

Eventually, investors will move out of expensive stocks because they will realize the companies simply cannot grow enough to justify the premium. Not everyone is an indexer. Private equity or other shrewd money will realize these non-index stocks are too cheap. Maybe even long-term patient money like pensions will snap up these non-index companies because they offer a superior risk/return profile over their extended time horizon. It will take less and less capital to move the non-index stocks because of their low market capitalization, therefore it will also be easier and easier to outperform the benchmark.

To assume that indexation destroys the financial system, assumes that markets do not work. I take the other side of that trade. Over the long run, markets are the best form of capital allocation and are better than anything else. Period. Full stop.

Yeah, there are periods when there are some inconsistencies, but eventually, markets arbitrage away the difference.

I don’t understand all the complaints about increased indexing. The more indexing, the less efficient the market becomes. The less efficient the market becomes, the easier it is to beat your benchmark. The easier it is to beat your benchmark, the more money flows from passive to active.

Do I think that the increased popularity of indexing is changing the behaviour of the markets? You betcha! Should you assume that trend will continue forever until it creates the ultimate nightmare scenario? Not a chance!

The current market is not all that different from other bull markets. I also don’t think humans change. They chase the hottest trend. That could be anything. They simply chase whatever is performing best. Lately it has been indexing.

At some point, indexing will become too popular. Just like everything on Wall Street – it will be taken to excess. Yet, at that point, active management will become significantly easier. It will no longer only be 29% of active managers beating their bench, but instead it will be 50%, 60%, or even 75%. Is that day today? No clue, but I bet it’s closer than most of the “indexing will kill us all” crowd guesses. Most importantly – I know it will happen long before the financial system implodes on itself.

I am confident that markets are self-correcting while also the most efficient allocators of capital, not sure why the other hedgies are so sure markets are wrong and always end in a nightmare scenario of stocks going no-bid.

Thanks for reading,
Kevin Muir

The MacroTourist

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