Free riding occurs when individuals exploit a common resource without for paying for it. People that jump the subway gates or don’t pay taxes are free riders. So are the slackers of a group project that receive the same grade as everyone while only doing 10% of the work. In the financial markets, passive investors are also free riders: they benefit from the efficient markets that result from active management, yet don’t incur the extra costs associated with research, trading, and portfolio management.
Consider the following thought experiment: Imagine you are back in college and enrolled in a new class, Financial Philosophy 101. On the first day of class, the Professor announces that the final score of your first midterm will be the average of everyone else’s score, except for the top 5 students, who will receive their actual grade. When exam time comes around, everyone studies hard to be in the top 5 and the average is an 85%, a solid B, and most people are satisfied. Before the second exam, your classmate Tom pulls you aside and tells you about “passive studying.” Why study hard when you can have a few drinks the night before the second midterm and settle for the average? No one wants to be the sucker that studies for three days and still underperforms on an opportunity cost-adjusted basis, even if there is a small chance of outperformance.
The above thought experiment roughly simplifies what happens in the financial markets, where passive index investors rely on active investors to do their homework to realize returns. Stock prices rise and fall because active managers trade on company earnings, product developments, and growth expectations. Without them, the market no longer incorporates the most recent information about a company – and is no longer efficient.
Because index funds can free ride for an average return, they are cheaper than active funds and are more attractive to most investors. They also offer better performance, as most active managers underperform their index targets while also charging a higher fee. As a result, money continues to flow out of the hands of active managers and into the hands of passive index funds. Active managers lost $500 billion dollars to index funds in the first half of this year.
What would happen if everyone invested in passive index funds? Without an efficient market, the price of a stock would only reflect its relative weight in an index. This represents a market failure, as the most efficient companies aren’t allocated the most capital, and investors don’t realize a return that is attached to any economic reality. In this situation, there is no incentive to invest in a stock that’s not in an index – regardless of its potential for earnings growth – since you know no one else will buy it. Why study for the test while everyone else is out having fun?
When deciding on how to invest his/her savings, passive management offers the obvious advantages of a low fee and a market return. However, there are several risks to consider. Market cap-weighted index funds and ETF's implicitly assume the largest companies by market-cap will continue to perform well in the future, although this is often not the case. Only three of the ten largest stocks in the S&P in 2000 remained in the top 10 in 2010. Active managers can also enact tax efficient strategies tailored to their clients, such as selling certain short-term losses to offset long-term capital gains. At the end of the day, whether active or passive management is a better fit often depends on an individual’s appetite for risk and size of investment. An individual with $30 million dollars won’t mind paying a fee for a defensive long-short strategy, but a young, inexperienced investor is probably better off settling for the free ride – the index fund*.
----------
*I'm using the term "index fund" here to refer to funds that track an index. These include index mutual funds and exchange-traded funds (also called ETF's).