Ehh, not quite. The author is indeed correct about the market-makers providing liquidity to everyone who wants to purchase on the day a company is added to an index.
But saying "index funds free-ride on the work done by active investors" and then following with "no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital to the right businesses" is FUD.
The value of the market represents the sum total opinion of everyone in it (plus noise), not just the managers of mutual funds losing business to index funds. Frankly, it sounds like the griping of someone telling fund managers that they deserve their fees, but the supposed loss from using index funds described in the original article (~.2%) is still dwarfed by the increased fees of actively managed funds.
Most index fund expenses are around .1-.2%, while most active funds come in at a whole 1-2%. To justify the cost of an actively managed fund, a manager has to not just beat the market, but trounce it. Very, very few can do so for any length of time, and they know it, which is why articles trying to convince people of the virtue of active fund management are constantly written. Unless your manager is as good as Buffett, buy an index fund.
The math is simple, but there's many fund managers out there trying to convince you otherwise.
Levine does not think you should invest in actively-managed funds.
The little coda about active management makes more sense if you read him religiously, because this is a schtick of his. Passive management helps most investors. But the market as an entity benefits from active management, because active management makes prices more accurate. This despite the fact that for the most part, contributing to the accuracy of prices comes at the expense of the actively-managed funds.
So without active management, the passive funds would perform more poorly, because their prices wouldn't benefit from the corrections of people trading into them to profit from mispricing.
Seconded. This is called the "Grossman-Stiglitz paradox".
There's also a kind of second-order version of market efficiency that says that active fund managers that can actually beat the market will increase their fees until their post-fee returns are the same as everyone else. So even if active _fund managers_ get compensated for making prices more efficient, there's no reason to believe that _fund investors_ will be.
Many years ago I did a comprehensive analysis of Canadian mutual fund returns over about 20 years, and found that the average return per year was dead on the market. The distribuiton of returns was Guassian and had a width of about 1%. I concluded from this that in fact fund managers can beat the market... by precisely amount they pay themselves.
This is evidence for the "second order version of market efficiency" your mention: it was uncanny, and put me into index funds for life (that, and the fact that there was no way of predicting from year-to-year which funds would beat the market the following year.)
I think too many people are erroneously conflating active fund managers with active traders, and my major objection to the article stems from how the author blurs the line between the two. But I admit, I'm not a regular reader of the author.
The market needs active traders for stock prices to accurately reflect investor opinion, but actively managed funds are not the only source of active trading.
I don't read him regularly, but I read it as him downplaying index funds as some sort of arbitrary, socially derived benchmark, which just isn't the case. He glosses over - he surely knows this given his background - all the efficient market theory that created the index funds in the first place.
There is a good reason that index funds are very difficult to beat consistently, and it's not because they are copying all the hard work everyone else does for fees. It's because you don't get paid for specific risk.
I didn't necessarily take him to be saying that. He is absolutely right that a market that is, quite literally, 100% passive would just sit there and not do anything -- it would just grow as money comes in, but there wouldn't be any relative movement of one share against another.
However, we are in no danger of running out of active traders, so there's no need for anyone to run out and sell their indexed investments to save the free market ...
Hmm, well, that wasn't the impression I got. Given the venue and audience, that part of the article felt more like it was giving fund managers the talking points they need to lure in unsavvy investors.
But saying "index funds free-ride on the work done by active investors" and then following with "no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital to the right businesses" is FUD.
The value of the market represents the sum total opinion of everyone in it (plus noise), not just the managers of mutual funds losing business to index funds. Frankly, it sounds like the griping of someone telling fund managers that they deserve their fees, but the supposed loss from using index funds described in the original article (~.2%) is still dwarfed by the increased fees of actively managed funds.
Most index fund expenses are around .1-.2%, while most active funds come in at a whole 1-2%. To justify the cost of an actively managed fund, a manager has to not just beat the market, but trounce it. Very, very few can do so for any length of time, and they know it, which is why articles trying to convince people of the virtue of active fund management are constantly written. Unless your manager is as good as Buffett, buy an index fund.
The math is simple, but there's many fund managers out there trying to convince you otherwise.