Indexing is a Form of Imitation

October 26, 2016

4 minute read

by David Merkel, Aleph Blog

I have sometimes said that it is common for many people to imitate the behavior of others, rather than think for themselves. There are several reasons for that:

It”s simple.
It’s fast.
And so long as you don’t run into a resource constraint it works well.

People generally have a decent idea who their smartest friends are, and who seems to give good advice on simple issues. If your neighbor says that the new Chinese food place is excellent, and you know he knows his food, there is a very good chance that when you go there that you will get excellent Chinese food as well.

You might even tell your friends about it; after all, you want to look bright as well, and its neighborly to share good information. That works quite well until the day that Yogi Berra’s dictum kicks in:

Nobody goes there anymore. It’s too crowded.

The information indeed was free, but space inside the restaurant was not, even if patrons weren’t paying to get in. And even if they have carryout, the line could go around the block… a hardship for many even if you are getting the famous Ocean Broccoli Beef. (Warning: Hot in every way.)

Readers of my blog know that the same thing happens in markets. Imitation was a large part of the dot-com bubble and the housing bubble. When a less knowledgeable friend is making what is seemingly free money, it is very difficult for many people to resist the temptation to imitate, because if it works for him, it ought to work better for the more knowledgeable.

As such, prices can get overbid, and the overshoot above the intrinsic value of the assets can be considerable. It all ends when the cost of capital to finance the asset is considerably higher than the cash flow that the asset throws off. And as with all bubbles, the end is pretty ugly and rapid.

But what if you had a really big and liquid strategy, one that threw off decent cash flow. Could that ever be a bubble? The odds are low but the answer is yes. It is possible for any strategy to distort relative prices such that the assets inside a strategy get significantly above intrinsic value — to the point where they discount negative future returns over a 5-10 year horizon. (As an aside, negative interest rates are by definition a bubble, and the instruments traded there are in big liquid markets. The severity of that bubble collapsing is likely to be limited, though, unless there is some sort of payments crisis. The relative amount of overvaluation is small, and has to be small.)

Indexing as Imitation

Today, indexing is a form of imitation in two ways. The first way is not new — it is a way of saying “I want the average result, and very low fees.” It’s a powerful idea and generally a good idea. If used for long-term investment, and not short-term speculation, it allows capital to compound over long periods of time, and keeps people from making subpar investment decisions through panic and greed.

Then there is the second way of imitation: indexing because it is now the received wisdom — all your friends are doing it. This is a momentum effect, and at some point even indexing through a large index like the S&P 500 or Wilshire 5000 could become overdone. The effects could vary, though.

You could see more larger private corporations go public because the advantage of cheap capital overwhelms the informational and other advantages of remaining private.
You could see corporations reverse financial engineering, and issue more cheap stock to retire expensive debt. On the other hand, it would be more likely that credit spreads would tighten significantly, leaving debt and equity balanced.
You would see pressure on corporations with odd capital structures like multiple share classes to simplify, so that all of the equity would trade at high multiples.
Corporations could dilute their stock to pay for resources — labor, land, intellectual capital and physical capital. Or, buy up competitors. If you think that is farfetched, I remember the late ’90s where it was cool for executives to say, “Let the stock market pay your employees.”
People could borrow against their homes to buy more stock, or just margin up.

If you see what I am doing — I’m trying to show what a distorted price for publicly traded stocks in an big index could do — and I haven’t even suggested the obvious — that an unsustainable price will correct eventually, and maybe, in a dramatic way.

I’m not saying that indexing is a bubble presently. I’m only saying it could be one day. Like the imitation illustrations given above, when a lot of people want to do the same thing without bringing additional information to the process, shortages develop, and in some cases prices rise as a result.

One final note: active management would get more punch at some point, because informationless index investing would lead to some degree of mispricing that active managers would take advantage of. At the rate money is currently exiting active management and going into indexing, that could be five years from now (just a guess).

As with all things in investing, the proof will be seen only in hindsight, so take this with a saltshaker of salt. As for me, I will continue to pick stocks. It has worked well for me.