Index Investing: Too Much of a Good Thing?
The merits of index investing are numerous with low fees, transparent rules, and minimal turnover among the most frequently cited advantages. However, not everyone views the rise of index investing as a good thing, and an increasingly popular debate has been the question of how much indexing is too much.
Since the global financial crisis, money has been flowing out of actively managed funds and into passive index funds. Estimates vary widely, but most sources put the share of total equity assets currently in index funds somewhere between 20% and 40%. A study by Moody’s Investor Services predicts that assets in passively managed funds will overtake actively managed in the next five years. If true, what impact could this have on the stock market?
A common criticism of index investing is that too much of it will make markets less efficient and price assets incorrectly, ultimately hurting index investors. At the extreme this may be true. The father of index funds, Jack Bogle, has even admitted, “If everybody indexed… markets would fail.” However, the reality is that total indexing will likely never happen and in the event index investing goes too far, active managers would quickly exploit any mispricing and drive markets back towards efficiency. Ultimately this argument around index investing is flawed because it focuses on the less relevant data point of total assets. The more important area to watch is the mechanism by which prices are actually set, the buying and selling of securities.
Despite nearly two decades of relentless asset growth, recent studies from Vanguard and BlackRock estimate that index funds still account for less than 10% of total trading volume in the stock market. Furthermore, total trading volume has more than doubled over this period which shows that the majority of buying and selling is still done by active market participants engaged in price setting. This evidence suggests that the growth of index funds has not distorted the market and is not close to doing so. Read our latest Economic and Market Commentary for Market Returns Year-To-Date, Market Returns Longer Term Annualized, Economic Indicators, and an Appendix.
Sources: Vanguard, BlackRock, AQR, Moody’s
This is intended for informational purposes only and should not be construed as legal, investment or financial advice. Please consult your legal, investment and financial professionals regarding your specific circumstances.