The Merits of Index Fund Investing

Whenever friends or students ask for advice about investing in the stock market, I always point to pooled funds as the preferred entry strategy for investing in assets that they may not be familiar with. Pooled funds allow the investor to take advantage of many benefits. Professional management will take care of the burden of selecting, monitoring, and trading securities. Diversification will reduce risks as the negative performance of one asset may be offset by the positive performance of another. Economies of scale are achieved as costs of transactions are shared among investors. Pooled funds can easily be bought and sold as needed. Finally, the minimum investment requirement is not so high.

But wait; as the sales pitch goes, it gets even better.

Modern portfolio theory has provided a good justification for adapting a passive investment policy that avoids security analysis. This strategy is called indexing. A passive strategy is based on the premise that securities are fairly priced and there is no need to scrutinize many stocks. One can simply select a diversified portfolio of common stocks that mirror the corporate sector of the broad economy. The investor chooses a portfolio with all the stocks in the broad market index such as the Phisix. The rate of return on the portfolio then replicates the return of the market.

In the US, more money today is invested in the passive way than in the active way. A recent The Economist article has, however, cited objections to this emerging trend. One argument is that indexing is bad for capitalism. A key role of financial markets is to allocate capital to the most efficient companies, but index funds fail to do this. Also, index funds pose a threat to competition. The asset management market used to be active and diverse, but if more fund managers take the passive approach, this can lead to the demise of a promising industry. But The Economist’s Buttonwood argues as follows, “Yes, if the market was 100% owned by index funds, that would be a problem. And if there were no crime, policemen would be out of work. But we are nowhere near that point.”

Most modern finance textbooks will argue that it is very difficult to devise supposedly superior investment strategies that beat the market. Yes, there will be rewards to especially diligent, intelligent, active investors who are able to trade at the onset of new information, but this is more the exception than the rule. A number of studies covering the performance record of professional active managers show it is possible, but difficult, to beat the market. And if all this empirical evidence is credible, there is indeed value in a passive index investing approach. So, to my friends and to anybody who cares to listen, I still say the index fund investing strategy makes good sense.

This indexing strategy appears to be naïve and perhaps even lazy.

However, in a truly competitive market, the forces of demand and supply will guide security prices to levels at which further analysis is unlikely to produce significant profit opportunities. The financial market is efficient if it provides funds at fair prices. A price is fair if investors will have equal access to all material information about risks and returns of the asset. Efficiency ensures that market players receive all price-sensitive information, and it will be very difficult to outdo each other.

A passive strategy based on index investing is worth considering, especially by new entrants to the equity investment world. Compared with the active strategy, the costs and effort are much less. It also provides free-rider benefits. Assuming many active investors are buying undervalued stocks and selling overvalued ones, the assets will be fairly priced most of the time. Thus, a well-diversified portfolio shown in the index is a reasonable investment. If we believe the overall Philippine market is following an upward trend, investing in the index fund is a winning formula.

The caveat to this strategy is that it relies so much on the assumption that the market is information-efficient. Many observers still believe, and understandably so, that certain parties in the Philippine market have better access to new information than the average investor. Thus, some quarters unsurprisingly achieve abnormal returns due to this distinct and unfair advantage. The thinking investor must be aware of this downside.

The views expressed here are his own and do not necessarily reflect the opinion of his office or of the faculty and administration of DLSU.

Benel D. Lagua is Executive Vice-President at the Development Bank of the Philippines. With an AIM-MBM and a Harvard-MPA, he is a part-time faculty of the Ramon V. Del Rosario College of Business of De La Salle University.

benellagua@alumni.ksg.harvard.edu