The Fine Print of Indexation

A look at opportunity costs, long-term risks and complementary solutions.

Over the last 50 years, equity indexes have morphed from simple performance benchmarks into a sprawling complex including thousands of low-cost investible products. In the U.S. alone, index funds now command 60% of total equity assets under third-party management, up from just 20% in 2011.¹

While we acknowledge the benefits of passive-investing’s low-cost revolution, we also believe it has introduced various hidden costs for index investors and increasingly threatens the price-discovery mechanism at the core of properly functioning markets. In this paper, we explore some perhaps misunderstood aspects of indexation, its potential long-term ramifications for markets, and complementary solutions we believe investors should consider.

As the cost of active management continues to fall, we believe it has growing potential to address indexation’s hidden costs while delivering attractive risk-adjusted returns and supporting the long-term health of the capital markets.

Indexation: From Benchmark to Bonanza

Markets are based on a fundamental mechanism: price discovery. When many participants strive to determine the worth of a security, price can maintain a dependable, if imperfect, relationship to value. This mechanism allows markets to function properly and ultimately helps maintain overall financial stability.

Indexation—an increasingly dominant force throughout the capital markets—has little to do with price discovery. Index-based vehicles track baskets of securities based on a criteria, such as the market capitalization of each company in the basket. This robotic approach keeps asset-management fees low in part by avoiding the analytical rigor required to model companies’ financial prospects and explicitly justify their valuations. While low fees have proven a powerful draw given that many professional active managers undershoot their performance benchmarks net of fees, we believe indexing also comes with hidden costs and gradually rising long-term risks for investors.

Nearly 140 years after Dow Jones created the Dow Jones Transportation Index in 1884, indexes have morphed from simple benchmarks created by data services companies into thousands of low-cost investible products sold by predominantly large asset managers commanding portfolios measured in the trillions of dollars. In the U.S., index-based equity pools—including open-ended mutual funds and exchange traded funds (ETFs)—now account for 60% of total equity assets under third-party management (AUM), a remarkable rise from just 20% in 2011 (see figure 1).

The Remarkable Rise of Passive Management

Source: Morningstar, as of March 2023.

To better grasp the potential impacts of this tectonic shift, we feel it helps to take a closer look at the evolution of indexation—as well as the powerful business model now churning beneath it.