In what way do index funds "free-ride on the work done by active investors"?

Question

I was reading Can You Really Game Index Funds?:

One of my little stock-market obsessions is that index funds free-ride on the work done by active investors. Someone needs to make decisions that allocate capital to businesses. A world in which everyone indexes, and in which no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital to the right businesses. That's not the world we live in: A lot of people still actively work to allocate capital, though they are in some regulatory disfavor and sometimes have a tough time making money. Part of the way they make money, or try to, is by trading against the index funds which free-ride off their labor, but which trade in a relatively mechanical, non-fundamentals-driven way. The index funds have the advantage of free-riding, but the disadvantage of being predictable. [...]

I understand the entire article except the parts in bold above. In what way do index funds "free-ride on the work done by active investors"? I have difficulties in understanding this assertion based on the contents of the article; the article does not seem to explicitly connect the assertion to the rest of the text.

Here's my guess based on preexisting knowledge:

Index funds are passive utilitarian investors. They do not know the "real values" of their holdings. Some active investors, in contrast, spend considerable resources on research to find the "real values". Passive investors do not have to conduct this research. The participation of active investors in the marketplace makes prices approximate their "real values". When prices reflect "real values", passive investors benefit despite not having spent any resources on research. In this way, passive investors are free-riding on the work done by active investors.

Did I guess correctly? In what way do index funds "free-ride on the work done by active investors"?

Answer 1

My interpretation is this:

If the only buying and selling of individual stocks was within an index, the prices would go nowhere. The index only gains or loses when the stocks within them gain or lose. The stocks within the index only rise (fall) value because there are active investors that buy (sell) the company stock based on the value of the company in and of itself, not because they are part of some index.

So the "gains" that indexes record are because the stocks individually record gains, and that is primarily done by active investing. The indices don't choose which companies to buy (allocate capital to), they buy stock because they are in the index. Only active investors allocate capital to "good" companies and take it away form "bad" companies.

Whether that's true or not is anyone's guess, but it makes sense.

Answer 2

I think your interpretation is pretty close to what the author probably had in mind. The general idea is that capital markets need some form of price discovery to function, and typically that price discovery is performed by active traders. Passive investors and, for that matter, active investors who trade infrequently, don't contribute much to price discovery, but they do benefit from it. Thus, the argument goes, they are free riders.

That said, I'm not sure I buy the argument. Much of the price discovery in markets is being done by market makers, high-frequency traders, and other such entities. These traders make substantial profits from their trading, and that is their compensation both for the risk they are taking and the service they are providing to the rest of the market. And who is it that pays for those profits? It's the people on the other sides of the trades, and often those people are the passive investors. So, in this view what is happening is that the active traders are providing a service, for which they are paid, and the passive investors are benefiting from that service, for which they are paying. That's not free-riding; it's a market working the way it's meant to.

Answer 3

It is a bit surprising that a Bloomberg OPED is so poorly written. The author does not explain his position so there is little wonder that you have to guess at what he means. The answer is, IMHO, is that only the author could tell you if you are on the right track.

Other ideas presented in the article are more simplistic yet somehow still difficult to grasp due the the author's style. I found myself having to decipher what he was saying many times rather than just understanding.

Your guess is a good one, and certainly not illogical. Is it correct? Maybe.