In the heyday of the two-tier market, the standard reply to investors skeptical of the quality growth stocks’ prices was: “Relax! The efficient market is at work; sophisticated analysts have found the underlying intrinsic values to justify the high prices of the tier-one stocks.” This argument might have been valid, except for one thing—a surfeit of converts.
Could too many converts undo the index funds? As they grow, liquidity may become a problem. A decision to add some names to the S&P 500 could force them into heavy buying. Suppose, for example, that $45 billion in index funds undertook to match the additions to the S&P 500 in the fourth quarter of 1975. This would entail buying $333 million of common stocks with a total trading volume of $5.7 million a day. Even with 100 per cent of the trading, the funds would need an average of 58 days to fill the positions dictated by changes in the index. If they took only 20 per cent—obviously a more reasonable assumption—they would need 290 days to make the transition.
One argument for indexing against the S&P 500 is that it escapes the pitfalls of a managed fund. But the composition of the S&P 500 is determined by the “500 Committee”—four or five employees of the Standard & Poor’s Corporation. In reality, the S&P 500 is just another managed fund. How would a lay jury judge a fiduciary who indexed against the S&P if investment results turned out badly? On one side, the jury would be hearing arguments on the esoteric aspects of capital market theory and efficient markets. On the other, they would be hearing about a fiduciary who delegated his authority to research and pick stocks to a committee he has never met.
Any equity portfolio involves risk. The risks will vary, manager by manager, philosophy by philosophy, technique by technique; moving from a fully managed fund to an index fund is merely trading one set of risks for another.