I’m skeptical of claims that passive indexing could cause price distortions, but for the sake of self-questioning I read the following article in the Financial Times. It’s one of the better critiques I’ve read.
https://www.ft.com/content/dbf88254-22af-11ea-b8a1-584213ee7b2bIt says, basically, that measuring everything in terms of performance versus an index has the following effects:
1) Asset managers whose performance is measured against capitalization weighted indices are pressured to buy more of assets/sectors with a rising price, lest their performance stray too far from their index. There is an agency problem here.
2) The mathematical impact on performance versus the benchmark is less for holding a declining asset/sector too long than it is for failing to immediately rebalance to buy more of an asset/sector that is rapidly rising.
3) Momentum investors jump on stocks as soon as an uptrend is apparent, thereby exploiting the benchmarkers’ requirement to rebalance some time later when a stock’s capitalization exceeds some threshold. The article implies there is some lag or threshold for index fund rebalancing that is higher than the lag or threshold for detecting a momentum trend. IMO this is the part that needs additional proof.
4) Small increases in stock prices start to snowball as momentum investors jump in, followed by index fund money. The result is a bias for higher asset prices (and I would think this forces us to conclude, more lumpy valuations, because some assets/sectors get this boost and others don’t).
5) Passive investors would be better off instructing their investing agents to pursue cash flows rather than price-based strategies such as keeping up with indices.
While I’m not sold on the validity of the argument that momentum investors are consistently able to prey on index investors, the article does describe a realistic cat and mouse game between benchmarkers and momentum investors that I would expect to increase the churn of both types of funds as they try not to let the other get ahead of them. The mathematical properties of compounding create this scenario where missing out on buying assets with rising prices is more costly than making a mistake than buying something that is about to decline (I.e. two days of 1% declines lose less value than is made by 2 days of 1% gains, so if you as an indexer wait until day 2 to rebalance, the momentum crowd who bought on day 1 is profiting against you).
So maybe don’t sweat it if your portfolio isn’t tracking an index.