Index Funds Surge In Popularity But Pose Risks For The Market

John Bogle once said index funds would never compromise more than half of the total mutual fund market. That was years ago. Morningstar
recently reported the total value of passively managed funds has surpassed actively managed mutual fund assets. Some are expecting index funds to top 70% of total mutual fund assets within the decade.

How much can the market share of these investment products grow? What happens to capital markets if that number hits 100%? More important, how might this put your retirement savings at risk? Finally, what opportunities present themselves to savvy investors as the market share of index funds grows?

Why have index funds become so popular?

As far back as 1996, two decades after Jack Bogle started the first index fund at Vanguard, index funds were barely a blip on the screen. Today, they dominate the market. Indeed, the six largest mutual funds in the world are all index funds.

“Investment in index funds has surged due to their low-cost structure, which aligns with the growing preference for passive investment strategies,” says Peter C. Earle, Ph.D, Senior Economist at the American Institute for Economic Research in Great Barrington, Massachusetts. “Additionally, the consistent outperformance of many index funds compared to actively managed funds has attracted more investors seeking higher returns. The rise of robo-advisors and increased awareness of the benefits of diversification through index funds have also contributed to their popularity.”

Testing the limits of index funds

Theoreticians and software programmers use a process called “the boundary condition test.” This process tests the sustainability of any theory or simulation in the most extreme scenario. If the hypothetical system breaks down under such conditions, it’s back to the drawing board.

You can easily imagine how to accomplish this thought experiment with index funds. You look at what could happen if index funds capture 100% of the investing market. Mind you, this represents a nearly impossible scenario. Even if all collective investment products (mutual funds, ETFs, common trust funds, hedge funds, etc…) became index funds, you’d still have individual investors who could opt to remain actively managed. (And, as you will soon see, it would be in their best interest to remain so.)

Are index funds safe for capital markets?

Should there only be index funds, strange things begin to happen in the capital markets. You might see this from three different vantage points: existing publicly traded companies, Initial Public Offerings (IPOs), and private markets.

Index fund dominance most immediately affects publicly traded stock markets. This stands as a simple lesson in economics. Publicly traded companies rely on competing valuations to drive price movement. Index funds mostly take this away. There is no longer a choice of which stock to buy or sell.

“The price of a stock is determined by demand and supply,” says Ernan Haruvy, professor at McGill University, Desautels Faculty of Management in Montreal, Quebec, Canada. “For that pricing mechanism to work to bring market information into the price, there must be demand and supply for each individual stock in relatively high proportion to overall trade.”

In the worst case, the boundary condition test suggests the capital markets can freeze under these circumstances. Existing publicly traded stocks will at least have their historic pricing to guide them. The same is not true for IPOs.

“It is likely that long-short funds would still enforce relative price movements, so I don’t see that markets would freeze for sure. But it is plausible that asset prices would be much more sensitive to movements in fund flows,” says Alan Moreira, Associate Professor of Finance at the University of Rochester Simon Graduate School of Business in Rochester, New York. “The IPO is a moment of price discovery, so it is impossible to imagine this market if there is not a single investor making an active choice.”

At first glance, privately traded companies appear to escape this, as there is no market index for this cohort. (That doesn’t mean you can’t create one). Yet, there is a domino effect should index fund capture the entire market.

“This is extremely unlikely, but if there was no one trading individual stocks—not even long-short funds—then there would be no price discovery of the prices of individual assets,” says Moreira. “This price discovery is often very important information in private markets as market participants use the price of other comparable assets to price the private deal. This happens for the same firm that is placing some non-traded security like private placed debt, or for other similar firms. For example, it is harder to value what should be the value of a new news-social network now that Twitter is no longer traded. In this case, this would happen across the board since no one would be trading on individual security information.”

Will the success of index funds lead to their demise?

You keep reading the hedging language that says the boundary condition of 100% index funds is not a reasonable scenario. Short of legislation outlawing actively managed funds, this makes sense.

As of right now, with index funds capturing 53% of the market, you don’t see any negative impact on the capital markets.

“Prices would co-move much more with retail flows into funds,” says Moreira. “I haven’t seen any evidence that this is happening.”

And you might never see this. Too many potential ‘leaks’ from a pure index fund environment exist. These back door modes of investing will only amplify as the index fund market share grows. The need for gains, essentially arbitrage opportunities, effectively places a cap on how much money investors would be willing to put in index funds. At some point, the expected gain from these arbitrage opportunities will surpass the expected gain from index funds. This could lead to a reverse capital flow from passive management to active management.

“Equilibrium requires a healthy proportion of gain seeking by the market,” says Haruvy. “There is no sign for this to not be the case. There is no fixed proportion of that gain seeking—just the existence of it and appetite for it.”

Will the markets ever approach a time when this equilibrium breaks down? Here, the thought experiment continues. The issue comes down to human behavior. Still, at least from a theoretical perspective, the ‘leaks’ are too prevalent to see this happening.

“There is no theoretical or empirical evidence that suggests a tipping point,” says Moreira. “It is important to note that even if ‘index’ funds reach 100% you can have: (1) lots of ‘index’ funds that are doing a variety of different things (following different indexes) and this way do lots of price discovery as investors flow in and out; (2) index funds can choose to have a tracking error and this way opportunity trade on individual assets; and, (3) long-short funds, funds that on net hold ‘0%’ could hold significant positions—both positive and negative—on stocks and this way impound firm specific information on prices.”

Are index funds safe for retirement?

The investing world is clearly entering new ground with index funds. Never have they consumed so much of the market. Even if theoretical, should you be concerned about the long-term implications the growth of index funds will have on your retirement savings?

“I think retirees are certainly better off investing in index funds, specifically very broad market-cap indexed funds,” says Moreira. “I don’t see any obvious risk for them.”

“Retirement savers benefit from this trend,” says Haruvy. “They are paying far lower management costs and enjoying greater stability of value. There is no downside to retirement savers.”

Rather than worry about the growth of index funds, perhaps it offers a new window to investment gains.

Profitable arbitrage opportunities during dominance of index funds

As more investors choose the passive route, there will be fewer competitors seeking to discover pricing discrepancies. This doesn’t mean it will be easy. It also means you’ll have to wait for the opening to occur.

“It would become much more valuable to do research on individual companies and trade on it since in this scenario no one is trading,” says Moreira. “Currently the evidence is that there are too many active managers in the sense that they don’t seem to make much money in aggregate.”

Once a critical mass of index fund investors is attained, nuggets will appear. Herein lies your greatest opportunity.

“If index funds indeed become dominant to where they stifle the market, then information will be sluggish to disseminate to prices,” says Haruvy. “Investors with even minimal news access will be able to reap quick and sure profits. Again, that is not likely to happen. That said, in the realm of IPOs and privately held securities, mutual funds that deal in those should see their gain rise if index funds become more dominant. Hence, a balanced portfolio between index and non-index is generally a good idea. Always.”

Ah, the ultimate boundary condition test. The advice is as old as Aristotle. The Greek philosopher considered moderation a virtue because it lies between the extremes.

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