Indexing is the Result of Homogeneous Markets, not the Cause

As indexing strategies gain in popularity I am seeing a common selling point from active stock picking fund managers – the idea that more indexing creates more opportunity for active managers. This appears correct on the surface. After all, if everyone started using index funds then this would create a homogeneous set of product wrappers that cannot accurately reflect the underlying companies.¹ But this myth gets the causation precisely backwards. It is not the indexing that is causing more homogeneous markets. It is more homogeneous markets that are causing the rise of indexing.

We know, empirically, that asset classes have increased substantially in correlation across the last 50 years. We also know that the global economy is becoming increasingly correlated as hyperglobalization creates one interconnected global marketplace. So, what’s happening here is that large corporations are all starting to look more and more like one another. More importantly, big sectors of the economy are starting to trend together as they ride this increasingly interconnected wave of growth.  So, what happens to the product wrappers like index funds as a result of this environment? Naturally, they evolve to reflect the changing market place. So we’ve seen a huge surge in indexing products that reflect the fact that “the market” has become increasingly correlated because the productive output of its underlying components has become more correlated.

But the big takeaway from this isn’t that more indexing will create more opportunities for more active managers. In fact, I would argue that this is precisely backwards. The increasingly homogeneous global economy is leading to an environment in which it is actually becoming more and more difficult to pick stocks and find companies that are uncorrelated. As a result, active stock picking managers should find it MORE difficult to outperform in this environment. And I suspect this will become an increasingly large problem for active stock pickers. After all, the domestic and global economies aren’t becoming less interconnected. As technologies advance and mobility increases we are only going to become more and more interconnected. All of this will make active stock picking and high fee active management an increasingly difficult activity as opposed to creating the opportunities that many expect.

¹ – Technically, this is impossible as passive indexing requires an underlying form of active management to make the index work in the first place.