Passive Aggressive

Index investing is evil.

The “tragedy of the commons” was a term coined by environmental guru Garrett Hardin in a famous article a generation ago. It goes like this: A group of herdsmen shares a common pasture. Each has an incentive to increase the size of his herd, since the costs of feeding new cattle are shared but the profit goes to the individual. Yet if each herdsman acts on his own seeming self-interest, the pasture becomes overgrazed and all of them are worse off. This fable about the price of selfishness and the benefits of cooperation has traditionally appealed to greens, social critics, and other worrywarts who fret over issues such as population growth.

The Internet is coming to illustrate the tragedy of the commons as well. Because that next e-mail or hour of Web surfing is free, or virtually free, for each of us, all of us suffer through slowdowns and, increasingly, breakdowns.

But Wall Street is where the tragedy of the commons is manifesting itself in a strange new way: through the rise of index investing. Indexing makes perfect sense for each of us, like dumping used paint thinner into the creek. Yet it would be disastrous if everybody did it, which in my book is a pretty good standard for deciding that something is wrong. Carried to an extreme, indexing is evil. I’m an index investor myself, yet it’s hard to come to any other conclusion.

This evil, like some others, has its roots in the academy. It springs from the theory that you can’t beat the stock market because all the information available is already known and accounted for. Thus, according to this “efficient markets” theory, you’re better off restricting yourself to a binary decision: to be in or not to be in. If the decision is to be in, just buy the whole market and relax.

You can do that by buying a basket of stocks that reflects the overall market, or some part of it. Some index funds mirror the Dow Jones industrial average or the Standard & Poor’s 500. Others track indexes of small firms, real estate investment trusts, even bonds. Index investors know they won’t do better than the market, but they also know they won’t do worse. And they save themselves the money and effort of trying. Indexing makes a virtue of passivity. There are no high-priced money managers to pay, and no need to spend time poring over the financial press.

Only about 25 years old, indexing is being embraced these days with good reason. This is likely to be the fourth year in a row in which most of those high-priced money managers don’t do as well as the Standard & Poor’s 500 index.

S&P figures that 8 percent of the $9 trillion invested in the U.S. stock market already is indexed, much of it from pension funds and other institutions that are required by law to invest conservatively. But an astonishing 17 percent of the $88 billion poured into ordinary mutual funds so far this year appears to have gone into index funds. That’s up from less than 3 percent in 1994. Net assets of index funds have risen from just $6 billion in 1988 to $125 billion today, and Vanguard’s Index 500 Trust probably will soon surpass Fidelity Magellan as the nation’s largest mutual fund.

Since most individual investors probably can’t hope to keep up with the pros, who in turn apparently can’t keep up with the indexes, doesn’t it make sense for everybody to index? Perhaps. The only trouble is that, if everybody tried it, there would be no stock market.

Indexing presents a classic example of the commons problem. The benefit we all get from people doing their best to beat the market is an efficient market–one where prices accurately reflect knowledge and expectations. Efficient markets are the whole basis of indexing, yet indexers depend on others to do the research required to separate good investments from bad. Indexers even boast about the low costs of their system. (Index funds have an edge of perhaps 1 percent a year over conventional mutual funds, because they have extremely low operating expenses.) Research is what provides a basis for most buy and sell decisions, and is thus crucial for establishing market prices. Indexers simply ride along for free, transferring these costs to others–who in turn have a greater incentive to index.

Index investing also makes markets less efficient by distorting the price of companies lucky enough to be included in the chosen indices. Already, companies admitted to the S&P 500 enjoy an immediate increase in the price of their shares.

But index investing doesn’t just undermine markets. At some level it also undermines economic health–the broader commons, if you will. If traditional investing rewards efficient companies and punishes slack managements, index investing perversely rewards mediocrity, rather like a business that pays lazy workers the same as industrious ones (or an economic system that rewards everyone equally no matter how much they produce). Indexers, after all, will continue to hold a weak-performing stock year after year, and will make no effort to double up on a strong performer. Under such circumstances, why would companies innovate, take risks, or try to grow? By making the economy less efficient and less responsive, index investing actually helps impoverish us all.