The Surprisingly Dark Side of Indexing

Sep 2016 //
Investing
Benchmarks

Every economy needs to make decisions regarding what companies and industries deserve the finite amounts of investment capital available in the economy.  For example, should cell phone producers or walkie-talkie producers receive investment capital?  Men’s blazers or leisure suits?  Widgets or gadgets?  In a functioning capitalist economy, investors essen­tially make these decisions every day as they choose which companies to invest in based on available information.  Historically this approach has worked very well to satisfy consumer demands and promote economic growth.  In a Marxist economy, central planners (government employees) make the decisions.  For example, in the Cold War days, USSR resources were directed toward producing ICBMs more than refrigerators—regardless of what the public wanted.  That’s typically not so good in terms of economic efficiency.  Lastly, in a supposedly capitalist economy where investment capital decisions are made by indexing (a prime example of passive investing), no consideration is given to any factors other than a company’s existing size (market capitalization).  Put differently, in a Marxist economy at least some consideration is given to various factors, whereas in a purely indexed economy, capital allocation decisions are basically static.  That’s why indexing is worse than Marxism—even when indexing doesn’t account for fully 100% of investment decisions.