Indexing strategies have been the fastest growing segment of the asset management world in the last 15 years due to low fees, tax efficiency, diviersification and the failure of higher fee active managers to justify their higher fees. As this trend plays out we’re hearing more and more stories about how this trend is bad for investors and how we need these old high fee active managers to better manage the asset space.

The latest story about the inevitable day of reckoning due to index funds comes from hedge fund manager Bill Ackman. Ackman’s flagship hedge fund has failed to outperform the S&P 500 by a wide margin in the last few years and his 2015 annual letter blamed index funds for some of the troubles.  How much of this is true though? Let’s explore some of Ackman’s comments in more detail.

First, we should note that much of the confusion in this debate stems around the mythical distinction between “active” and “passive” investing. As I’ve noted many times before, the market is comprised entirely of active participants whose level of activity ranges from silly (high fee day trading, for instance) to intelligent (your typical Boglehead type of approach often referred to as “passive indexing”). Since “the market” is comprised of ONE portfolio of all outstanding global financial assets and all market participants deviate from this globally cap weighted portfolio then the distinction between active (those who try to beat the market) and passive (those who try to capture the market return) is far murkier than most would have you believe.

This distinction is important to understand because the rise of less active investors creates greater opportunities for more active managers. This is due to the fact that a “passive” product requires active management. For every passive investor who doesn’t want to waste time and money buying every stock in a stock index fund there is a more active manager or market maker ensuring that that product trades at the net asset value that that less active investor desires. Indeed, passive investors pay active investors in various forms (spreads, market data fees, arbitrage, etc) for owning their less active product. Some active managers like high frequency trading firms and other market makers have made gobs of money during the rise of index funds thanks largely to the efficient way in which they make the indexing process operate. There is no clear distinction between active and passive investing because passive investing necessarily requires an active manager just like a market requires both a buyer and a seller. But let’s move on to some of Ackman’s claims.