Financial Innovation: More Research Needed
The premise of Bob Litan’s “In defense of much, but not all, financial innovation” seems to me to be straightforwardly mistaken. He seems to think that there’s some large chance that US politicians are imminently going to clamp down on financial innovation, and therefore that it’s important to tilt against the idea of a default position of skepticism. Where I’m sitting, the Chairmen of the relevant committees in the House and the Senate reject the anti-innovation point of view, as does the President of the United States, and all three are from the party that’s less hostile to the idea of new financial regulations.
But he mounts many interesting arguments, and certainly is persuasive that commentators have been too quick to speak dismissively of “financial innovation” without considering the full breadth of innovations that have been brought onto the market. But the paper is essentially qualitative in nature, which makes the scoring process he uses seem a bit arbitrary. Things like this section on the GDP impact of index funds seem to me to be best interpreted as a call for more efforts at conducting quantitative research:
The expense savings afforded by indexed funds also is indicative of a productivity gain (delivering portfolio diversification more cheaply than active management) totally apart from any improvement in investment performance. At the same time, however, there are potential economic costs to indexing, which is why it would not be good for all mutual fund assets to be indexed, even the vast majority of actively managed funds that fail to consistently out-perform the indexes (and even if substantially more fund assets were invested in a broader index, such as the Wilshire 5000, which avoids biasing capital toward a narrow base of firms, such as those belonging to just S&P 500 or 100, or to the Dow Jones 30 industrials). Indexing removes incentives for shareholders to monitor companies as intensively as they would if they owned shares in the companies directly. On the other hand, because there is some stock market premium associated with membership in the more exclusive indexes, the strong demand for indexed funds provides incentives for firms to grow. On net, therefore, I would give indexed funds a + on their contribution to productivity and GDP growth.
This is all persuasive to me accept the final sentence. Someone should actually try to measure the magnitude of these impacts. Not so much because we need to know whether index funds are “good” or “bad” but because it would be useful to know something about the likely impact of policies that either nudge people toward indexes or to actively managed funds. For example, if we think an aggregate shift of small investor savings in the direction of indexes would have a positive impact on GDP growth, then we should change the rules governing 401(k) accounts to try to get more money into indexes. Conversely, if index funds have some kind of deeply deleterious impact on corporate governance that might be a problem.