My S&P 500 ETF is being attacked by monsters from the Id (and David Einhorn)! What do I do?

A reader asks: My S&P 500 ETF is being attacked by monsters from the Id (and David Einhorn)! What do I do?

Archer replies: Shakespeare’s The Tempest is a tale of betrayal and revenge set in motion by a shipwreck. That plot line was later picked up by the 1956 sci-fi classic Forbidden Planet, starring none other than future all-universe detective Frank Drebin, known in everyday life as Leslie Nielson, and on the movie’s fictional planet Altair IV as Commander Adams.

Altair IV was once home to the Krell, a civilization a million years ahead of humans but that has now vanished, leaving behind only a vast underground power source that “could give physical form to any matter they (the Krell) could conceive of,” including thoughts both conscious and subconscious, per the Wikipedia summary.  Adams commands a spaceship sent to investigate the disappearance of the crew of an earlier mission to the planet. They arrive to find everyone dead except Dr. Morbius (Walter Pidgeon) and his daughter, Altaira, the young Anne Francis. Romantic entanglements ensue.

But love is not the only thing in the air. The arrival of Adams and company seems to have unleashed a superhuman force, a “monster from the Id,” that now stalks the space travelers. Close followers of the father of psychoanalysis will remember that the Id is defined as the most primal part of the human psyche, responsible for aggression and sexual drive. Whose Id are we talking about here? Hint: Morbius, who has lived alone with his daughter for many years, is not keen on her falling for Adams/Nielson. Possibly the Krell technology has provided him a glimpse of the police detective’s future film oeuvre.

At any rate, as the movie hurtles towards its climax, it dawns on otherwise perceptive Morbius that it is his own subconscious that has created the monster, and that the Krell machine has imbued it with essentially infinite destructive power.

The call is coming from inside the house.

The growth in index funds is similarly setting off alarm bells. The “monsters” behind this nightmare scenario aren’t coming from the Id, however; they’re coming from Princeton, New Jersey and from Valley Forge, Pennsylvania, home to Burton Malkiel and (the late) John Bogle, respectively, both hugely influential advocates of passive investing.

In his book, A Random Walk Down Wall Street, first published 1973 and now in its fifteenth edition, Malkiel argues that the average investor is better owning low-cost, broad-based index funds than trying to beat the market through active investing. Bogle’s Vanguard is the sponsor of one such fund, The Vanguard 500 Index Fund, with around $1 trillion in assets as of mid-February.

But this idea wasn’t initially very popular. As Malkiel told CNBC in 2020, “When my book was first reviewed by a professional in BusinessWeek, they said it was the biggest piece of garbage in the world, ridiculous advice.” But demonstrably, most active managers don’t beat the market averages on anything like a consistent basis. And in spite of that poor early review, Malkiel’s idea caught on; earlier this year Morningstar reported that for the first time ever the majority of U.S. investment funds were passively managed.

Not everyone sees this as a good thing. Hedge fund manager David Einhorn (Greenlight Capital) recently told Bloomberg, “I view the markets as fundamentally broken. Passive investors have no opinion about value. They’re going to assume everybody else has done the work.”

Einhorn (and others) are concerned that by becoming the market, index funds risk destroying the market. Or, as Adams says to Morbius, “That thing out there. It’s you.” Has it (the market) reached a tipping point? The jury is still out on that one, but the debate is heating up. As Bloomberg columnist John Authors recently wrote, passive investment “is increasingly cast as an agent of destruction, breaking markets and fighting capitalism.”

The arguments pro and con can be a little abstruse but the biggest one comes down to this: without active trading you have no way to establish the price of an asset, there is no “price discovery.” You can value stocks anyway you want – by p/e, by cash flows, by the astrological chart of the CEO, etc. but in the short term at least there is only one thing that matters – how much will someone pay for it? 

How much of the market needs to trade to reasonably establish prices? Opinions differ. Charles Ellis, a key figure in the indexing revolution, has suggested the figure may be somewhere north of 80%. Malkiel thinks that it may be higher as does Rob Arnott of Research Affiliates. Einhorn clearly feels markets are already disrupted.

All this remains highly speculative at the moment. Bloomberg’s Matt Levine has had a running joke (I think) in his newsletter along the lines of “should index funds be illegal?” In a recent column he cites a paper called “Indexing and the Incorporation of Exogenous Information Shocks to Stock Prices,” by Randall Morck and M. Deniz Yavuz. These two blather on a bit about “endogeneity” and “exogenous idiosyncratic currency shocks” before concluding that “Increased indexing thus appears to be undermining the efficient markets hypothesis that supports its viability.”

So there. Others suggest that markets will self correct as the approach of “peak indexing” creates the conditions for active managers to outperform. Time will tell. But one thing is for sure — there will always be those who believe they can beat the averages. That is, as Prospero, said, “the stuff dreams are made of.”

Woof.

(NOTE TO READERS: My new book, Radical Problems, Simple Solutions: How Markets can Help Fix the Retirement Crisis and Solve Wealth Inequality is now out. To purchase a copy and support your local independent bookstore, go to Flyleaf Books.)