Free Riding and Indexing

Free riders exist in any economy. It's not a great way to structure a system, never mind a society. It's generally considered an economic problem, in that certain individuals consume more than their fair share of a resource without cost.

In one sense, an index fund is a free rider. (1) The fund sits around and reallocates resources to the stocks or bonds in the market class, letting the active players in the industry do all of the heavy lifting, and take all of the expense, valuing the companies. Once the market capitalization changes on an individual stock, the index adjusts.

For example, in a lot of the towers in New York, asset managers spend time studying the details of businesses. Committees then meet. Everyone jokes around about how ridiculous Powerpoint is and then everyone dives into the Powerpoint presentation. Among a lot of blue dress shirts (hey, what's wrong with that!), theories get handed out that sound good and reasonable.

"Electric cars are consuming huge amounts of lithium in their batteries. This is going to drive the share of miners in Chile" or "I really think Saudi Arabia is going to have a water problem given that it's like 100 degrees and they have a lot of people and a lot of desert." To the people sitting in the meeting thinking about what show they're going to watch on Netflix tonight, these sound like reasonable thoughts and one person asks some questions to seem smart and then everyone agrees electric cars need lithium and desalination is important and the asset manager buys some shares.

An instant later, the index rolls in and says "Thanks for your hard work, we agree, let's do this. P.S. we're not paying you anything for your research."

But then across the street in New York, one floor down but close enough that you can kind of see the meeting across the street when the lights are on, there is another asset manager presentation. And this woman is saying "Look, I think everyone knows that we need a lot of lithium and that is all priced in already. And Bill Gates has been a bit distracted recently because his PR machine fell apart, but still, he's a smart guy and he's got all these investments in new battery technologies and they don't need to haul stuff out of the ground in Chile, somehow get it on a boat to the U.S. when there aren't any boats available, and so I think we should sell those miners." And the committee agrees and they sell.

And an instant later, the index says "You are also correct, that was an excellent point! An instant ago the world had not considered that. So we're right behind you, selling. And oh, once again, no fee."

Note that, if indexing got too big, an economic problem would set in from this free riding, as there would be no one to price the securities. But I doubt that is going to be a problem, given human behavior and the enticing incentive of playing the stock market.

Dan Cunningham

1. I said "In one sense" because it's not a foregone conclusion that an index fund is a free rider. Here's a counter-thought. If indexing is pulling smart financial people away from active management, that could be making active management easier. Perhaps active management's primary problem is that they have too many smart people competing. See this Morningstar article for more discussion.

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