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Why Invest in Indexes? The last section showed that index funds offer easy trackability over market hours. What are the other pros and cons? On sound microeconomic principle, professional asset management will add value over index results before deduction of fees. Otherwise they couldn’t stay in business. The same principle says that the fees will converge to that pre-fee value added. Price converges to marginal utility (value). Investors bid fees up when fees are less, and down when they are more. As a rule of thumb, investors should expect to do equally well in managed or index accounts when fee costs are considered too. The mechanics of convergence is worth a look. Managed and index funds compete in a kind of density-dependent flux like hawks and doves in game theory. It pays to be a hawk when the hawk/dove ratio is too low, and a dove when too high. When hawks have only hawks to fight, they will win only half the time. Fighting becomes a losing strategy when it risks more than winning stands to gain. More doves will mean easier contests. So it is with asset managers. Index funds (doves) avoid commitment (fights) as to which firms and sectors will outperform. This neutrality saves the costs of research needed for commitment (fights). Asset managers (hawks) pay those costs, and recover them when outperformance results. That means outperforming the index. But if asset managers collectively managed the whole market, they would become the index. Some would outperform others, but the whole group cannot outperform itself. Then it could not recover its research costs. Many would have to close their doors, leaving the field to index funds which don’t pay those costs, until market equilibrium was restored. Then what determines equilibrium? Is the critical variable percent of trades by managed funds? I thought so for a while. Now think it’s percent of AUM (market value of assets under management). My reasoning now is that holds by portfolio Chapter 8 Banks, Money and Macroeconomics 2/8/16 8 HOUSE_OVERSIGHT_011097