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Are Index Funds Communist?

With what seems like a obsessive focus on passive investing led by investors, regulators and lawyers focused on fees, a Bloomberg columnist raises an interesting question: Are index funds communist?

Before you dismiss the columnist – a former investment banker at Goldman Sachs and an M&A attorney on Wall Street – consider his arguments: Active markets reward good companies and punish poor performers. Indexing, especially market-cap weighted indexes, reward companies that are big and keep getting bigger. New innovative companies, the argument goes, will have a harder time getting capital to grow.

But most newco’s don’t rely on public markets to start, some will argue. And don’t venture capitalists invest in companies that have the potential to go public and garner big returns?

The author lays out three choices in allocating assets to companies:

1. Get it wrong and the economy suffers, which is communism.
2. Get it right, which is nearly impossible.
3. Let the market decide, which is capitalism.

If more and more assets keep flowing into passive investments, aren’t the decisions about which companies get funding made by the people who create the indices? Which leads to arguments for smart beta – which does not pick stocks, but looks at indicators beyond market cap. Will computers be the “activists” of the future, predicting which factors lead to growth and higher returns?

The problem with advocating against indexing is that in good markets they do well, and in bad markets they deliver what was promised. Indexing leads to the abandonment of the pursuit of knowledge by people trying to predict future trends and rewarding companies that are innovative. Do we really want to abandon this pursuit – even if we get it wrong some of the time?