In the past few months I’ve seen quite a bit of social media speculation that passive investing could cause the next big stock market crash.  Many people express genuine concern about recent news articles claiming that the rise of passive investing poses serious threats to market stability.

I see the same questions repeated in these online discussions:

1. Should prudent investors avoid passive investing options?
2. Will the rise of passive investing cause a widespread market melt down?
3. If passive investing causes a melt down, how can investors protect their wealth?

The mindful investor favors so called “passive investing”, which for the purposes of this discussion, I will define as using mostly index funds.  (I’ve discussed before that the “passive vs. active debate” is a false dichotomy that often confuses the discussion, but I won’t pursue that tangent today.)  I’ve presented copious statistics in past articles showing that you will most likely get better returns by picking a moderately diversified set of low-cost stock index funds, as compared to trying to pick “the best” actively managed funds or individual stocks.

So, I’m somewhat alarmed that these scary-sounding news articles might dissuade otherwise reasonable investors from index investing.  Of course, as mindful investors, we can’t dismiss these media fears without first considering the evidence.  Because index investing was a minor part of the market in the 2000s, and hardly even existed before the 1990s, perhaps something unprecedented will happen as index investing gains an ever bigger share of the markets.

In this post and my next post, I’ll look at a cross-section of recent articles expressing concerns about passive investing, as well as some academic research on the subject.

Primary Concerns about Index Investing

The most common concerns I found about the rise of index investing and its potential market impacts are:

• Index investors are “freeloaders” and “parasites” that burden the efficient operation of the wider market.
• If everybody becomes an index investor, the markets will stop functioning and collapse.
• More index investing will cause more volatile market swings from larger bubbles to deeper crashes.
• This amount of index investing is a new situation that’s inherently chaotic and unpredictable.
• More indexing may cause persistently higher stock valuations.
• The rise of indexing has concentrated assets in a few large firms, which makes the market highly dependent on the continued financial health of these few big players.
• Index investing via Exchange Traded Funds (ETFs) could cause problems due to how ETFs are used and traded, particularly for leveraged index ETFs and inverse index ETFs.

These concerns are fairly widespread.  Although I provided a link to a single example article that discusses each of these concerns, in all cases I found multiple articles airing similar concerns.

The last concern is intricately coupled to the issue of ETFs and how they work, which is a huge subject by itself.  During my quick review of the ETF-related concerns about indexing, it seemed to me that most of the arguments offered would apply nearly as much to actively managed ETFs as they would to index ETFs.  There may be a valid concern about the intersection of ETFs and indexes, but it seems like a stretch to claim that index investing is the primary cause of this particular problem.  So, I won’t cover this concern in detail, although I may come back to it in future posts.

In the rest of this post, I’ll evaluate the first two issues, which represent the most fundamental fears about the rise of index investing.  In Part 2, I’ll cover the remaining concerns, which get into some more nuanced aspects of index investing.

Index Investors are Freeloaders

The “freeloader” argument contends that there must be market participants that are actively engaged in what is called “price discovery” for markets to work properly.  These active investors regularly attempt to determine the fair and best value of many stocks and bonds.  They then buy the under-valued ones and sell the over-valued ones, which causes prices to more accurately reflect true valuations.  The argument goes that as more investors use index funds, which buy stocks or bonds in the index regardless of their price, stocks and bond prices could become ever more arbitrary, which in turn will cause serious market instabilities.

The obvious problem with this argument is that it relies on an analogy of the freeloader, or some writers prefer the even more loaded term “parasite”.  Drawing a compelling-sounding analogy doesn’t make the analogy necessarily true or correct.  I could just as easily say that, because index investors don’t trade based on price fluctuations, they form the foundation of the market and provide valuable stability.  A foundation is a nice-sounding analogy too, but that doesn’t make it any more true than the freeloader analogy.

Regardless of the merits of the freeloading analogy, professional investor Cullen Roche finds the this argument transparently false:

• “[T]he less active [index] investors are paying fees along the way in order for the index to exist in the first place.  The classic example is when an index fund introduces new holdings.  Research shows that the passive investors forgo much of the gains that active managers earn when they bid up the price of that new entrant.  In essence, the less active investor is paying a higher price to ultimately own that new entrant.  You might not see the “fee”, but the less active investor certainly “pays” the more active investor for that new holding.  The more obvious example is basic market making.  An index fund market maker is earning a bid/ask spread all along the way as an index exists.  Again, you might not see the fee come out of your pocket, but you are “paying” that fee in the form of higher prices.  Lastly, indexers pay management fees to index fund providers for the economies of scale that they benefit from.  This certainly isn’t free even though it’s low cost.”

These examples show there’s a lot of price discovery going on in and around index funds, and that passive investors do indeed “pay” active investors for their price discovery work.  So, I think we can dismiss the “freeloader” concern as hyperbole.  But the next concern adds some more rational meat to the bone of the freeloader analogy.

What If Everyone Indexed?

The logical extension of the freeloader analogy is that when everybody uses indexes, there will be zero price discovery taking place in the market, and so it will no longer be a market in the typical sense.  In fact, the father of index investing, John Bogle noted:

• “If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.”

But wait a second.  Why would the guy who started Vanguard, the largest provider of index funds in the world, agree that index investing is going to kill the markets?  Bogle is willing to agree that 100% indexing would be a disaster, because he knows that universal indexing is a literal impossibility.

How Much Indexing Is There? – To understand why universal indexing is impossible, we should first understand the statistics behind the “rise of index investing”.  You’ll find many claims about how much of the market is now in index funds, and some of those claims seem almost purposefully misleading.  Here’s a scary chart from Goldman Sachs showing fund flows, which implies that index investing is swallowing up the market in one continuous gulp.

But what’s the net impact of these fund inflows and outflows?  I found these relatively objective facts:

• Index funds made up 15% of all U.S. fund assets in 2007 as compared to 35% in 2017.
• Morningstar found that 47% of U.S. stock fund assets* are in index funds as of April 2018.

Index funds represent a fair part of the assets that are in funds of one type or another.  But not all market assets are in the form of mutal funds or ETFs.  How do index funds compare to all of the assets in the stock market?

• Famous index advocate Charley Ellis estimates that less than 30% of U.S. stock assets are in index funds.
• Blackrock found that stock index assets represent 18% of the global stock market in 2017.
• And UBS estimates that index assets represent only 8% of the total global stock market.

Some have questioned these statistics, because they exclude active funds that may be “closet index funds”.  That is, some actively managed funds mimic indices but still charge higher management fees.  While this hidden indexing assuredly exists to some extent, I couldn’t find a numeric estimate on the amount of closet index funds in the market.  The fund managers involved understandably want to hide from that sort of categorization.

Even if we add a fudge factor for closet indexers, it seems pretty clear that stock indexing now represents less than a third of the entire U.S. market and probably less than a quarter of the global market.  While this shows that many investors have jumped on the indexing band wagon in the last couple decades, we still aren’t even close to a situation where indexing has “taken over” the markets.

Further, is the percentage of assets by fund type even the right measure to understand the potential effects of indexing on price discovery?  After all, the Cullen Roche quote above explains there is already quite a bit of price discovery surrounding index funds.  Blackrock estimates that active investors trade $22 in stocks for every $1 traded by index funds, or about 4.5% of trades.  And Charley Ellis clarifies that the amount of trading action is a better measure of price discovery activity:

• “First, while index funds and exchange traded funds (ETFs) now approach 30 percent of stock market assets, their turnover is so small compared to that of active investors that they account for less than 5 percent of trading, and trading is what sets prices.”

I got this quote from an article by Michael Batnick, who goes on to point out that there’s much more trading activity today than historically.  Trading activity has increased for many reasons, but algorithm trading using computers is certainly one reason.  He notes that it’s typical for 10% to 15% of a large stocks’ outstanding shares to change hands in just one month, which equates to nearly a 100% turnover in a year.  That seems like plenty of price discovery to keep the markets functional.

The Future of Indexing – But what happens as the current trend continues all the way up to a 100% indexing?  The question sounds reasonable, but it assumes that the current rise of indexing will continue unabated.  That assumption is clearly false.

Starting with Bogle, he notes that as indexing grows, it creates easier and easier opportunities for active investors to exploit any miss-priced assets.  Many experts that are mostly ignored by the news outlets echo this observation.  For example, Charley Ellis points out that near universal index investing would be such a ripe opportunity that some investors would invariably exploit the inefficiencies, which at some point would reverse the decline in the active share of the market.

Cullen Roche explains that these opportunities are already exploited today:

• “The second important understanding is that a[n index] investor…needs a more active investor to make the underlying index work.  For instance, when an index fund is purchased, its price will necessarily change relative to the underlying basket of assets.  If the price of the index rises above the asset value of the underlying basket, then a market maker will sell the index and buy the underlying basket.  They will buy that underlying basket from someone who is being even more active than they are as they buy the right quantities of each component.  So, in order for an index to work you need a pyramid of more active investors to help make a market in the first place…the idea that “everyone might index”. That is literally impossible.”

Given it’s already true that index investing causes some active investing, why would anyone assume that this interaction would suddenly stop in the future?  Personally, I’d love a market where I was the only active investor.  I’m sure I could quickly make billions.

It’s pretty clear that index and active investing will reach some sort of equilibrium as measured by percentage of assets in the market.  But no one has the crystal ball that shows the exact location of that equilibrium point.  Bogle guesses the equilibrium could be around 75% index investing.  In a very detailed post at Philosophical Economics, the author guesses the equilibrium might be more like 90% indexing.  And given the amount of trading going on today, it’s highly plausible that a small percentage of active investors could engage in enough price discovery to keep the markets functioning.

The Answers

Going back to the three main passive investing questions regularly kicked around in social media, we’ve got some pretty firm answers for the first two.

1. Prudent investors should still favor passive investing options.  These media articles all argue that passive investing will cause widespread mayhem that won’t be limited one type of investment or another.  So, even if you believe index funds are the next “toxic” investing product, there’s no way you can avoid a market-wide crash by simply switching to active investing.
2. The “rise” of passive investing won’t cause a widespread market melt down.  Even a cursory review of how markets work indicates there will still be plenty of active trading and price discovery taking place, even if index funds start to represent the majority of assets in the markets.  Further, index investing can’t overtake the entire market, because more active investors will inevitably step in and exploit any increasing inefficiencies.  The most likely scenario is that some sort of dynamic equilibrium will form between index investors and active investors, which will keep the markets functioning well.

Conclusions

Some attentive regular readers might notice that these answers rely to some extent on the opinions of some experts and reject the opinions of other “experts”.  As I’ve noted before, the mindful investor should not simply accept the opinions of experts without convincing empirical data.  So, it’s important to note some things about these scary media articles:

• They usually present scant supporting evidence beyond a few statistics on index fund flows or percent of indexed assets.
• They rarely, if ever, discuss more informative statistics on trading.
• They rarely, if ever, discuss the mechanics of how index funds interact with the more active market.

In contrast, the experts debunking these concerns almost always address these details.

And I think it’s reasonable to pay more attention to an expert that accepts objective facts that we’ve already independently verified.  Specifically, experts like John Bogle, Charley Ellis, and Cullen Roche are extremely well-known for endorsing the efficacy, and even superiority, of index funds, which is a fact that I’ve supported with mountains of data here at Mindfully Investing.  And when it comes to these more basic facts about index investing, I don’t know whether these scary news authors have well-reasoned opinions or not.

I’ll leave the third and last question about passive investing to Part 2 of this series, where I’ll discuss some of the more nuanced concerns expressed about the rise of passive investing.  In the mean time, I suggest you keep holding your index funds.

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*Note that this value of 47% is for stocks only, while the previous estimate of 35% appears to include both stock and bond funds.