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Have you ever heard the expression ‘The Tragedy of Commons’?

It’s an economic term that means an action benefits the entity committing it, but the costs of that action are diffused, or spread out to everyone. An example of this would be a manufacturer whose actions end up polluting the air or water. The phrase is commonly used in economics, and it can apply to financial markets as well.

We’ll explore why that is in this post.

The Truth About Indexing

Why is indexing called The Tragedy of Commons?

The argument is that the goal of indexing — higher returns over the long term because of lower costs — only continues as long as the market underneath the index is active. The buyers of the index are the ones who benefit, but the healthy market has to be maintained by the shareholders in actively managed funds and people who buy and sell the individual shares.

No market can exist without people doing research and analysis, and conducting the buying and selling that comes with that. Likewise, regulation of the market is necessary as are the businesses that make up the market. People who hold index funds mostly avoid the associated costs and drive up the costs for those who don’t invest.

It’s gotten to the point where John Bogle, the founder of Vanguard Group and the man who basically started the trend of index investing, recently said that this kind of behavior could create a vicious cycle that could lead to tragic events in the stock market. “If everybody indexed, the only word you could use is chaos, catastrophe,” he was quoted as saying. “The markets would fail,” he added.

If there are no active investors setting prices, he pointed out, and only indexers, then trading would dry up. There would only be people who bought or sold the market. Fortunately, the market isn’t entirely owned by indexers, and Bogle has made sure to note that as indexing increases, opportunities for investors to exploit inefficiencies in the pricing of some stocks will open. Anything after that, however — his view is beyond 75% — will make the market dangerous. While he didn’t elaborate on this, it’s easy to infer his meaning. As indexing comprises a growing segment of trading, the smaller number of active market participants would cause large price swings in individual shares and maybe even the market as a whole.

What Can Be Done

The good news is the market still has a long way to go before stability is threatened. About a fourth of U.S. stock ownership is through indexing, according to Bogle. According to

Morningstar, 46.7% of assets in U.S. stocks via exchange-traded funds or mutual funds were indexed in April of this year, and that number is up from 36.3% three years prior.

There is one development that could take away the advantage index funds enjoy, thus slowing their purchase, but it isn’t likely going to be popular. In order to make it happen during a long decline in the markets, active managers could get ahead of indexers by moving assets into cash or what are perceived to be safer investments like utilities and consumer staples. If that happened, owners of index funds would hurt financially a lot more than owners of actively managed funds. Their losses would also be tougher because the illusion of security in owning the market instead of trying to beat it would be shattered. Active investors might be able to gloat for a little while because index fund owners have been gaining at their expense but, ultimately, the price swings would mean losses for everyone.

Indexing is likely to pick up the pace until the next bear market hits. The practice of indexing is a consideration for each person, but it becomes less of a good idea as more people do it. When things take a downturn, they will have to be their own managers and make sure their holdings are diversified, with as little exposure to risk as possible.

If you have any questions about investing, don’t hesitate to contact me with any questions.

 

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Passive management is a style of management where a fund’s portfolio mirrors a market index. Active management is when Investment managers attempt to outperform the market by predicting market activity, and can add value to portfolios by anticipating market cycles and continuously changing asset allocation over time. No strategy assures a profit or protects against loss. All investing involves risk including loss of principal.