THE BLOG
09/23/2014 12:44 pm ET Updated Nov 23, 2014

Indexing and the End of Capitalism

It's now official. The tipping point for investing in stocks by using index funds is here. It is impossible to pick up any business publication without reading about Indexing, passive investing, Warren Buffet's will (in which he advised his heirs to put his estate in Vanguard index funds), and the massive money-flows into index funds themselves. There is a monthly scorecard recapping the amount of money put into index funds vs. actively managed ones. The revenge of the economic professors who first pointed out that it was "mathematically impossible" to beat the indexes over time or consistently find managers who could do so is complete. The belief has trickled down to the mom-and-pop investor, who now believes indexing is the way to go. Smart money managed by pension funds does too.

Karl Marx very astutely predicted that capitalism was rife with contradictions and that long term would destroy itself. He argued the seeds of revolution could be found in inherent short term thinking and the greed factor. To Marx, capitalism's encouragement for the misallocation of resources would bring misery to all.

Karl Marx never met an index fund. If he had he would have added this phenomenon to his list of capitalism-destroying mechanisms.

How so? While it is probably true that via backtesting of investment results, ninety percent of fund managers cannot beat the passive indexes, it is also possibly true that the seeds of economic decline lie in the attempt to right this wrong.

The stock market exists to funnel excess capital to businesses. Via selected capital allocation, the market is supposed to reward winning businesses, those with good prospects and generous shareholder distributions, and punish businesses that destroy shareholder wealth. This is/was supposed to be the whole point of stock analysts with their numerous tools and methodologies, i.e. P/E ratios, return on equity and free cash flow, etc. The reward for good business/shareholder stewardship was higher priced stock and the multiple benefits that accrued. Both management and shareholders had a stake in the game. Boards of directors were supposed to oversee management's progress in boosting equity value and the resulting share price. Managements that failed to do so were supposed to be removed.

This is capitalism 101. Indexing throws that all out the 60th floor window. With indexing, the game is to get listed. This is even greater with pure index funds that do not use market capitalization metrics to reflect the weight of a company in the index. Now, if you can get listed on a stock exchange, oodles of cash will flow your way from the investing public just because...they have to. Forget any of the dozens of grading metrics that would rank and compare your company. Forget any measure of quality of earnings or future business strategies. Not one of these is relevant if you are indexing your investments.

Your indexed portfolio will be chocked full of questionable companies like Groupon, and high-fliers like Netflix and Amazon. As the few remaining speculators drive their prices ever higher, you will be forced to buy more!

Indexing rewards bad behavior or makes it irrelevant. Indexing would have given its fair share to Enron, and the dozen of other fraudster companies that went bust. The few analysts that discover fraud and short companies will be relics. When indexing takes over, it will be like the tree falling in the forest; no one will hear a hedge fund's short strategist's negative assessments, because there will be no way to profit by it. Cash will dutifully flow into the listed indexed companies regardless.

You don't have to be a Marxist to understand that this flies in the face of the very premise of capitalism. Rewards to all according to their listing. What will be left is a bloated mass of capital, blind and indifferent to past returns. Companies could eliminate all dividends. Why bother to pay cash to indexed shareholders if you will be treated the same as the company that pays? Why not just distribute all the earnings to management? The passive indexing approach guarantees a floor under your share price. Why even bother to worry about valuations? If all indexes keep receiving fresh funds, there is no reason to look at valuations.

Also, forget socially responsible investing. Indexing guarantees that a polluting, child-labor using, and regulatory-evading company, will suffer no consequences whatsoever. Why turn up at the company annual meeting if it will have absolutely no effect on management?

Envision a quarterly conference call between management and whomever. (Remember there will be no analysts on the call. They are extinct.) It will go like this: The company CEO will start the call by announcing that the AJAX enterprises has successfully kept its listing on the relevant stock exchange. He will thank everyone for listening and hang up.

I can hear Karl laughing from his grave.