Could The Popularity Of Index Funds Reach A Danger Point?
August 03, 2017

Could The Popularity Of Index Funds Reach A Danger Point?

Popularity isn’t always good. Sometimes it breeds the delusion that nothing could go wrong. We’ve seen it with popular singers or actors who build cult-like appeal. If they start to believe that they’re infallible they sometimes end up wrecks.

Plenty of people help the process. And the media swoops in if they think they see a weakness. So what’s the investment world’s equivalent? It might be index funds.

CNBC reported that investors piled $236.7 billion into U.S. stock market index funds in 2016. In contrast, they discarded actively managed funds like yesterday’s coffee-stained paper. Americans pulled $263.8 billion from actively managed funds last year.

According to Morningstar, investors now have $581 billion in Vanguard’s Total Stock Market Index (VTSMX). Investors have $329.3 billion in Vanguard’s S&P 500 Index (VFINX). Vanguard is now the world’s biggest mutual fund company. No other actively managed fund company comes even close.

Vanguard used to battle Fidelity and American Funds for the number one spot. But according to Investment News, with almost $3 trillion under management, Vanguard now has almost as much as the other two combined.

It’s easy to see why index funds are popular. According to the SPIVA Scorecard, the S&P 500 Index beat 92.15 percent of actively managed large-cap funds over the ten-year period ending December 31, 2016. The S&P Mid Cap 400 Index beat 95.4 percent of actively managed mid-cap funds. The S&P Small-Cap 600 beat 94.64 percent of actively managed small-cap funds.

Some actively managed funds do beat the market. But it’s tough to continue to do so. Index funds are relentless. They almost always catch up.

That said, some financial experts say there’s a dark side to investing with index funds. They say the popularity of passive investing has created its own problems. Michael Blanding, writing for Forbes magazine, quoted George E. Bates, Professor and senior associate dean for International Development at Harvard Business School. He said, “We are now in a situation where index investors are the major shareholders in most of the large- and medium-sized public companies in the United States. That raises the question, who is exercising control in these corporations?”

George Bates argues that a company’s management might become complacent if it doesn’t have to impress individual shareholders. In theory, if most of a company’s ownership comes from index fund investors, the company price will rise in proportion to its weighting in the index. If a company’s management team makes plenty of mistakes, it won’t be accountable for those mistakes. The share price could keep rising (if people keep buying the index) even if the company’s management makes dimwitted decisions.

Reality, however, is likely to intervene. If a company’s share price stops reflecting its business profits or losses, active investors are going to notice. For example, if somebody offered you $1.50 for the $1 in your pocket, wouldn’t you want to sell?

Most rational people would. Fortunately, there are still plenty of people who take advantage of mispriced stocks. Vanguard’s Chris Philips says most of the money in the market isn’t invested in index funds. Referencing Morningstar he says, “Index funds constituted 14 percent and 3 percent of equity and fixed income funds, respectively, in market-capitalization terms. That means more than 85 percent of the equity market and more than 95 percent of the bond market were invested in some form of active management, be it individual securities, hedge funds or managed accounts.”

Indexing doesn’t appear to be at the point of taking over. But some people ask, “What if everybody indexed?” First of all, human beings aren’t that rational. There will always be millions of people or institutions that want to pick their own stocks, buy lottery tickets or gamble at casinos. Long odds don’t matter. Human nature won’t be altered if there’s a possible (however remote) way to beat the system.

But let’s assume pigs started to fly and the entire world decided to build a portfolio of index funds. If that happened, the prices of stocks, relative to their intrinsic values, would get completely out of wack.

For example, a company that didn’t increase its business profits–while experiencing an ever-rising stock–would catch the eye of opportunists. They would swoop in to sell or short the stock. As their active trading generated more success, others would soon follow. As a result, it would once again make the markets more efficient.

Index investing has also taken on many roles. There are high dividend paying indexes, equal-weighted indexes, value indexes, growth indexes, small-cap, mid-cap and low-volatility indexes. Even among index fund investors, the flow of investment money rarely moves to the same place. Smart beta investing will unwittingly do its part to make sure the market is efficient.

Index funds might be popular among retail investors. But just 14 percent of investable money sits in index funds. That’s not the kind of popularity that will go to anyone’s head.

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