Tuesday, December 19, 2017

Rethinking Investment Strategies: Is Passive Investing Leading to a Stock Market Ponzi Scheme?

A Ponzi scheme is a deceptive strategy that entices investors with the allure of high returns and minimal risk. It functions by using the investments of newer participants to pay returns to earlier investors. Bernie Madoff's scheme remained in operation for many years, only unraveling when investors sought to liquidate their investments. However, why would one even consider drawing parallels between index investing and a Ponzi scheme?

Read more: Ponzi Scheme

I have been a steadfast advocate of index fund investing for the long term. In fact, all my investment accounts are exclusively comprised of index funds or exchange-traded funds (ETFs) that closely follow various market indices. An index fund is a specific type of mutual fund meticulously designed to replicate or track the components of a market index, such as the renowned Standard & Poor's 500 Index (S&P 500).

Read more: Index Fund

Among the pioneering index funds, the S&P 500 index fund stands as a notable example. Today, there is a proliferation of indices tracking nearly every conceivable sector, capitalization, and international market. It's safe to say that if you can name it, there's likely an index fund tailored to it. For a comprehensive list of Vanguard index funds, you can refer to this resource.

The S&P 500 index fund, in particular, has demonstrated a remarkable track record of outperforming actively managed funds over an extensive time frame. The graph below vividly illustrates how the S&P 500 index has consistently outpaced other equity funds throughout a 25-year period (1980-2005). This enduring performance highlights the enduring value of index investing.

Courtesy: Vanguard

Index funds are exceptionally cost-effective when it comes to their expense ratio (ER). Their cost-efficiency can be attributed to the minimal management, or passive, involvement required in maintaining an index fund. These funds primarily adhere to a buy-and-hold strategy, minimizing the need for frequent trading and active decision-making. This streamlined approach not only reduces costs but also aligns with a long-term investment perspective.

Courtesy: flatfeeportfolios

Investing in index funds is fundamentally rooted in the Efficient Market Hypothesis (EMH). The Efficient Market Hypothesis is a prominent investment theory that posits the impossibility of consistently "beating the market." This assertion arises from the concept that stock market efficiency leads to the perpetual incorporation and reflection of all pertinent information within existing share prices. In essence, the EMH underpins the rationale behind index fund investments, emphasizing the challenges of outperforming a market where information is swiftly absorbed and factored into stock values.

Read more: Efficient Market Hypothesis - EMH

While it might seem feasible to outperform index funds like the S&P 500 in the short term, the story changes when considering longer time frames, such as 5 to 10 years. As exemplified in Warren Buffett's 2008 bet against the hedge fund industry's ability to surpass a typical S&P index fund over a decade, the index fund's consistent performance has been a vindication of his stance. On a personal level, I've experienced instances of outperforming the S&P 500. These achievements typically occurred over relatively brief time frames, often within six months or less, involving the selection of one or two top-performing stocks. However, sustaining this success over an extended period proved challenging. The inherent risk associated with such strategies was notably high, and the rewards remained unpredictable, highlighting the enduring appeal of index fund investments.

There is a growing debate about whether the Efficient Market Hypothesis (EMH) remains entirely valid in light of the emergence of Financial Technologies, often referred to as FinTech. FinTech, a fusion of "financial" and "technology," characterizes the burgeoning financial services sector in the 21st century. This sector's disruptive innovations have raised questions about the traditional notions of market efficiency and the degree to which information is instantaneously absorbed and reflected in asset prices. The impact of FinTech on market dynamics continues to be a subject of significant discussion and exploration.

Read more: Fintech

Prominent companies such as Betterment and Wealthfront provide investment products that align with the principles of Modern Portfolio Theory (MPT). Modern Portfolio Theory is a well-established investment theory that operates on the premise that risk-averse investors can strategically design portfolios to either optimize or maximize expected returns within the constraints of a predetermined level of market risk. These innovative companies have embraced the core principles of MPT to offer investment solutions tailored to the preferences and objectives of a wide array of investors.

Read more: Modern Portfolio Theory (MPT)

The challenge lies in the transformation brought about by these innovative companies, democratizing and commoditizing investment like never before. In the past, gaining access to an index fund required a minimum investment of $3,000, typically through a platform like Vanguard or Fidelity. It was an option to opt for corresponding ETFs, albeit incurring a $7 commission fee, and even then, the possibility of acquiring fractional shares was nonexistent. However, with the advent of these pioneering FinTech firms, the landscape has shifted significantly. Now, it's not just feasible to invest with fractional shares, but the barrier to entry has plummeted to as low as $10. This accessibility and affordability have opened the doors of investment to a wider and more diverse audience, fundamentally altering the investment landscape.

I am wholeheartedly supportive of making the benefits of stock market returns accessible to a broader audience. In fact, I encourage it. However, a potential challenge arises when individuals who invest through these modern platforms may lack essential financial knowledge or an understanding of their risk tolerance. What's more, many of them place unwavering faith in the Efficient Market Hypothesis without delving into the fundamental valuation of the underlying stocks. It's important to recognize that the Efficient Market Hypothesis is most accurate when there is a significant degree of active management in play. We rely on the collective actions of individual stock traders, hedge funds, and other actively managed funds to continually identify the winners and losers within the market. This dynamic interplay is integral to market efficiency, and an absence of active participants may influence the market's performance differently.

I hold concerns that the substantial surge in the commoditization of the stock market could lead to a substantial increase in assets being funneled into passively managed stock portfolios. In the event that the proportion of passively managed assets surpasses a certain threshold, let's say 50%, there arises a legitimate question about the continued validity of the Efficient Market Theory. The balance between active and passive management plays a pivotal role in market efficiency, and an overwhelming influx of passive assets might potentially disrupt this equilibrium.

At this juncture, I hold the view that index funds might eventually exhibit characteristics akin to a Ponzi scheme. This would occur as long as new inflows of investments continue to pour into these index funds and ETFs, perpetually propping up the stock market. Given the prevailing demographics and the steady influx of younger generations into these investment instruments, this scenario could indeed be a reality. A telling illustration of this transformation is depicted in the image below, where there's a discernible net outflow from actively managed funds, emphasizing the shifting landscape of investment strategies.

Vanguard presents a remarkable array of actively managed funds, featuring exceptionally low expense ratios. One standout illustration is the Vanguard Wellington Fund, a timeless investment vehicle that has stood the test of time since its inception in 1929. This enduring fund has weathered numerous stock market downturns, including those of the Great Depression and subsequent recessions, underscoring its resilience and enduring value.

Courtesy: Vanguard

I hold a personal belief that passive investing through index funds is a sound and effective strategy. However, a critical question arises when the capital invested in passive instruments closely rivals, if not surpasses, the capital allocated to active instruments. In such a scenario, it becomes debatable whether the Efficient Market Hypothesis still retains its accuracy. In my perspective, at this juncture, the theory might no longer be applicable, and the stock market could potentially adopt characteristics akin to a Ponzi scheme.

It's important to note that the sustainability of such a scenario could be influenced by the significant exposure of index funds in retirement accounts like 401(k) plans and the proliferation of FinTech companies. Nevertheless, I also believe that in the long run, equilibrium may be restored in the market.

I'm curious to hear your thoughts on this matter. Do you concur with my assessment, or do you hold a different viewpoint?


  1. Hi Geek, This is an interesting topic for me. I feel that if indexing continues to grow to a larger share of all investing, eventually the market will become inefficient. We do need active investors to set market prices. I think if indexing becomes too large, active managers will have an advantage and exploit the price inaccuracies. An equilibrium will then be reached between active and passive. Tom

    1. Agreed. But as a index investor (mostly through 401s or ETFs) how do we secure our position?

  2. @dividendGeek - Very interesting topic. I also believe that index funds and the lower barrier to entry today provides a bit of an artificial floor for stock prices.

    1. Precisely. Question is do we continue to invest in index funds?

  3. Got to admit, interesting line of thought! How about the impact of the variety of index funds, not all have the same contribution and will affect the market at a broader level. That being said, think Tom has a point, at a certain time an equilibrium will develop.
    Guess it would only become a Ponzi scheme when there would be only a few very large once left that control the market.
    Good point, thought provoking!

    1. Well I hope Tom is right. A little worrying as almost all my investments are in index funds :-)

  4. Love this post, DG. Almost nobody wants to question something innate like this. While I have been a proponent of indexing for a few years, theres a lot that I do not like about the industry. The setup is interesting, where liquidity flows into selected group of companies, which are picked by a few people who create the indexes. Moreover, they change index methodology constantly, and keep adding and removing companies -- which goes against the spirit of indexation. Passive investing is definitely a big bubble that needs to burst sooner or later, and its an interesting viewpoint to pose it as a question whether its a Ponzi scheme.

    Great post


  5. I'm not too worried about indexing being TOO popular as I think the pendulum will swing the other way eventually especially once there's a recession and people want to move to funds that manage towards safety.

    I think there's an opportunity for funds that have some short exposure now that all these stocks are getting bid up because of their inclusion in index funds.

  6. Interesting explanation.
    You've made some pretty good points

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