Knocking indexing

Jun 28, 2009 @ 12:01 am

By Sara Hansard

Despite the widely held view that indexing is the safest way to invest, not everyone is a proponent.

Indexing actually “helped recklessly drive our financial system and economy into the ditch last fall,” said Scott Cleland, president of Precursor LLC, a McLean, Va., industry research and consulting firm.

“All the rules and oversight in the world can't keep us out of the ditch in the future if index vehicles continue to drive the wrong way against oncoming traffic,” he wrote in a June 11 blog titled “Indexing into the Ditch — Financial Crisis Root Causes, Part I.”

“Stress testing whether bank vehicles can survive head-on crashes completely misses the point that indexers should not be driving the wrong way on the freeway,” Mr. Cleland wrote.

A major reason that the financial system has become so unstable and dangerous to financial security is that more than 10% of money management vehicles are indexers. “By design, [these] drive the wrong way against the oncoming traffic of a market economy that allocates capital based on economic merit,” he wrote.

As more investments are indexed, it could lead to economic gridlock, Mr. Cleland wrote.

Index funds represent $1.5 trillion, or about 12% of all mutual fund assets.

Many managed funds feel pressure to “closet index,” Mr. Cleland wrote.

Indexing naturally amplifies market volatility because it artificially creates a massive one-sided market, he wrote. It generates substantial supply with no offsetting demand in a down market, and it generates substantial demand with no offsetting supply in an up market.

Famous index proponent John Bogle, founder of The Vanguard Group Inc. of Malvern, Pa., e-mailed his view that Mr. Cleland's thesis “is nuts! Last time I looked, index funds accounted for about 0.4% of all stock trading ... Just perhaps the other 99.6% might bear a teeny-weeny bit of the responsibility.”

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