What I mean by this is that the appeal of indexation strategies is great when there is enough active stock picking going on to make a market efficient to the point that you cannot reliably identify stock-picking skill in advance (or do it yourself). The more market participants participating in an auction system, the less chance there is of finding gross pricing errors (or of being able to determine skill in advance).
I don’t think it’s a stretch to view the stock market as an equilibrium system. As new equilibrium points are reached with respect to how much of the dollar weighted investment portfolios are indexed versus actively managed the appeal of indexation changes. I mention this because many people have questioned what would happen if many more people were indexing. What if the entire market was indexed? Who would be setting prices? It wouldn’t actually work, but I don’t think that’s something that we will ever encounter either.
But let’s assume that the majority of the market was indexed. The same math always applies: the passive investor net of fees will beat the average active investor, however it could be easier to identify the skilled manager in advance. Of all the actively-managed portfolios, some will beat the index and some will lose out to the index – this is how it is now too. The difference is that the application of analysis and research would more likely be fruitful endeavours.
Take this quote from the father of security analysis, Benjamin Graham, from 1976:
“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”
So as more and more people index the market, a new equilibrium will be reached. Eventually active stock picking can be a reliably worthwhile activity again – but as it stands today, it is not for large and efficient markets.
Moral of the story: low-cost index funds are a prudent alternative to actively managed (long-only) portfolios in today’s day and age. That may change as indexing becomes more popular (and markets less efficient), but given human nature that may not happen.