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The Market Inefficiency Risk Created By Index Fund Domination

Dear Speculators,

Theoretically, equity market investments provide the most attractive returns of any financial market. Since investors assume higher risks when purchasing common stocks, they are rewarded with high returns if the risk fails to materialize. Value conscious investors invest capital in stocks to gain returns in excess of inflation whilst moderately increasing their real wealth. However stock picking and market timing are two very important elements of investing that most (if not all) investors are still yet to perfect. While active money managers for decades have tried to outperform the market, very few have achieved this feat. This has increased interests in passive investing over the last few decades. In fact the introduction of index funds which allows investors to earn market returns at very little cost has provided investors an opportunity to quit fighting and accept the inevitable that they just can't beat the market!
Today index funds manage trillions of dollars around the world. Many fear that indexing may cause asset prices to deviate from their intrinsic value which will make the stock market less efficient. Market inefficiency may occur because index investors do not trade stocks based on the expected performance of individual companies rather it's ideology is that the law of large numbers will protect investors who purchase bad or overvalued stocks since on the average there should always be more decent performing stocks than poorly performing stocks thus providing the index investor with a positive return greater than the risk free rate with less risk, less cost and less stress. While the argument may have a bit of sense attached to it, it dangerously plays down the economic hazard of inefficient prices and misallocation of one of the most important resources to production and growth, CAPITAL. Since poorly performing firms can receive capital more than they require or deserve due to discrepancy in stock prices, this will prevent excellent companies who require additional capital from getting the full capital that they deserve.
To prove the unsustainability of the indexing strategy and its harm to market efficiency, one would have to imagine a world where the stock market is fully capitalized by index funds. Stocks prices will fail to react to changes in the economic fundamentals and only respond to changes in the flow of money in and out of index funds. New securities included into the index will receive capital not based on merit but simply because these companies went public. This then creates a moral hazard problem as investment bankers will now simply unload into the market worthless companies at exorbitant prices since nobody seems to care about the quality of the businesses they invest in as long as they are listed in the capital market. A period of market bubble and potential financial doom will ensue as the rate of financial crimes will rise to its highest level ever in human history. Investment bankers will steal trillions from unsuspecting ignorant investors. Once investors realize the level of financial crimes permitted by indexing, it will lead to a period of massive cyclical outflows out of index funds to actively managed funds. Giant bubble build ups will pop and the market will endure the world ever financial depression. A few investors will be able to get out early but many won't be so lucky. But at least investors will again learn something new from history that no investment strategy can be overdone and still remain valuable.

Emeka Ucheaga,
Managing Partner,
Emeka Ucheaga Advisory

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