In the world of high finance, few people are as respected and credible as Bill Ackman. The Harvard-educated CEO of Pershing Square Capital Management, who started his hedge fund company in 2004 with $54 million of his own and his partners’ money, now manages well over $6 billion for institutions and wealthy families. In his annual letter to clients reporting on performance in 2015, Mr. Ackman included comments on index funds and their impact on the capital market.
Points we agree with
Mr. Ackman starts his discussion of index funds by stating that they have been increasing their market share, which is correct, at least at the retail investor level. If we look at U.S. mutual funds and ETFs, the market share of index funds (as compared with actively managed funds) has doubled from 16% to 32%1. Mr. Ackman also recognizes that “index funds and ETFs have very low fees and have outperformed the average manager in recent years.” We agree with this, though we believe index funds outperformed not only the average but the majority of comparable actively managed funds.
Points we disagree with
Mr. Ackman makes the point that the most popular index funds—which track, for example, the S&P500 (large cap) index—tend to attract more than their fair share of new money, and that consequently, stocks that are members of such indices are overvalued. As a result, according to Mr. Ackman, stocks outside the indices are better investments. We feel this argument doesn’t hold water. Consider that mid and small cap index funds are also very popular. For example, the iShares S&P Mid Cap and the iShares Russell 2000 (small cap) ETFs are among the largest ETFs in the U.S. What's more, mid and small cap companies respectively account for 20% and 10% of the market value; therefore, they don’t have to attract as much capital as S&P500 funds to get their “fair share” of money flows. Consequently, once we add up the securities from these three indices, there isn’t much left to invest in.
In his letter, Mr. Ackman also writes: “While value investors buy more as stock prices decline, market-cap weighted index funds do the opposite. They are inherently momentum investors, forced to buy more as stock prices rise, magnifying the risk of overvaluation of the index components.” In fact, index funds do not have to buy more of a stock because it is rising in value. The weight of a stock in an index fund will increase if this stock appreciates faster than the rest of the market, because it then represents a larger share of the market. But purchases and sales made by index funds are not at all driven by stock price changes.
Index funds, despite their simplicity, are still misunderstood by many among the public and by experts as well. At the same time, index fund gains in market share are made at the expense of active investment companies. It would be very convenient for such companies to find a serious flaw in index funds. But to date, they have not. Index funds are not perfect. But when their strengths and weaknesses are put in the balance, they represent a great value proposition for most investors in building a well-engineered, diversified portfolio.
1 Source: Morningstar Direct