Of index investing and traditional Medicare

For some time, a kind of inverted analogy between index fund investing and Traditional Medicare has been flickering round the edges of my mind, so let's see where it leads.

I was very impressed by a forecast I heard almost exactly eight years ago (Suzanne Duncan of the IBM Institute for Business Value)  that within 20 years, 85-90% of assets under management would be invested in passive vehicles -- that is, index funds or institutional equivalents. And in fact, in 2015, passive funds accounted for a third of U.S. mutual fund assets, up from a quarter three years prior.

For individual investors, and for most institutional investors, the shift to passive investment makes excellent sense. It's almost impossible for a portfolio of actively managed funds to beat an index portfolio over time. Just today, the Wall Street Journal reports, "Over the 15 years ended in December 2016, 82% of all U.S. funds trailed their respective benchmarks, according to the latest S&P Indices Versus Active funds scorecard."  And of course, index funds retain a huge fee advantage, since they don't have to pay managers for their acumen -- the funds change their investments automatically to mirror a predetermined basket of equities or bonds.

Someone has to make active decisions that determine prices, however, thereby creating the indexes that passive investors rely on. That means investing in research, complex mathematical analysis, and, sometimes at least, intuition born of lived experience.  What happens when the indexed values are produced by managers investing, say, just 5% of all assets under management? Isn't that a rather small brain moving a dinosaur? Is a smaller herd of decision-makers likelier to stampede in destructive directions?

Conversely, Medicare Advantage -- what you might call actively managed healthcare for seniors -- is grabbing a growing share of the Medicare market, now up to 32% of the whole, up from 22% in 2008.

The end of money management as we know it?

At Investorside's Independents' Day conference of independent research providers on April 8, Suzanne Duncan of the IBM Institute for Business Value reported some startling results from a study of the current state and likely future of the financial industry. Undertaken jointly with the Economist Intelligence Unit and the CFA Institute, and surveying 848 financial markets executives worldwide and 107 of their corporate clients, the study found:

• 70% of the institutions' corporate clients said that their providers put their own interest first, not their clients'. 60% of industry executives surveyed admitted to the same thing.
  
  
• Only 10% of hedge funds deliver alpha -- that is, do what they're paid to do.
  
  
• Within twenty years, 85--90% of assets under management will be invested in passive instruments such as index funds.

That last forecast (if correct) means pretty much that the money management business as we know it is going to evaporate --though Ms. Duncan, asked what the near-end of active investing meant for the analysts filling the room, did suggest that there would be demand for research (and presumably advice) in asset allocation.

I asked Ms. Duncan: if 85-90% of funds are passively managed, who's going to set prices? She said that academics who have made even more radical forecasts have suggested that price discovery can be adequately handled by those managing just 5% or even less of total assets.

Personally, I'm all for index investing. I've always suspected that 90% of hedge funds were frauds, and that only the best-endowed institutional investors, such as the the top Ivies, had both the acumen and the financial clout to get into the relative handful of truly effective hedge funds under favorable terms. But as Jonathan Clements, the former Wall Street Journal personal finance columnist and evangelist for index investing (now Director of Financial Guidance for Citi's fee-only MyFi advisory service) once wrote, those of us who invest in index funds and other passive vehicles are parasites in a sense, profiting from the collective wisdom of active managers without paying for it. Though I'm not qualified to judge, it strikes me as dangerous to have multi-trillion dollar markets depend for price discovery on the active investment decisions of those managing a tiny fraction of the total assets.