In my last post I examined some spooky claims that the rise of passive investing could cause the stock market to collapse.  It turns out that the scariest of these claims overlook some important details about the mechanics of markets and index funds.  In fact, it seems nearly impossible that widespread passive investing through the use of index funds would cause basic market functions like “price discovery” to break down.  (Price discovery is where active investors try to buy undervalued stocks and sell overvalued stocks resulting in price adjustments that more accurately reflect “true” stock values.)

In my last post I also listed some more nuanced concerns about the possible dangers of index investing including that:

• More index investing could cause more volatile market swings from larger bubbles to deeper crashes.
• The recent popularity of index investing is a new situation that’s inherently chaotic and unpredictable.
• More indexing may cause persistently higher stock valuations.
• Most indexed assets are concentrated within a few large firms, which introduces a new risk to the markets should one of these firms become financially unstable.

In this post I’ll examine these four additional concerns about index investing and try to determine whether mindful investors should take any action to protect their portfolios.

Index Investing Could Increase Market Volatility

In my review of various articles on passive investing dangers, I found three main claims for why increased index investing might result in larger market swings.  Let’s take a closer look at each one.

Not Enough Active Investors – The first claim is that too much index investing means there won’t be enough active investors to “stabilize” the markets in a crash.  This claim is a reworking of the same basic argument against index investing that I covered in my last post, which is that indexing will somehow destroy the normal price discovery process.  In my last post I showed that there’s more price discovery surrounding index funds than these claims recognize.  Increased price distortions caused by index investing would present ever more obvious buying opportunities for the remaining pool of active investors, and it might even spur some active trading by normally passive investors too.  It seems unlikely that the basic human desire to make easy money would suddenly evaporate in the future, at least to the extent that these same desires helped “stabilize” past crashes*

Index Investors Will Panic – The second claim is that those “passive” index investors might panic and actively sell during a crash, which would exacerbate the decline.  While the first claim worries that passive investors will fail to act, this second claim worries that they will act too much.  I’m tempted to frivolously argue that half of passive investors will panic and the other half won’t, resulting in zero net effect.

But on the serious side, at least the “passive panic” claim recognizes that index fund investors are still subject to normal human foibles.  It seems plausible that safe-sounding index fund products may have lured some investors into stock investing who don’t have the necessary temperament (risk tolerance) to ride out typical market storms.  And Jack Bogle has expressed concern that Exchange Traded Funds (ETFs) in particular encourage bad behavior, because ETFs can be traded throughout the day, while mutual funds cannot.

However, this all seems to blame index investors for acting like, you guessed it, active investors.  Consider the low percentages of active fund managers who were able to beat their indices in the last three bear stock markets:

• 2001: 35%
• 2002: 32%
• 2008: 44%

Even as prices were collapsing, most active funds were selling and buying stocks in a way that caused even greater losses for their funds.  Both active and index fund managers must buy and sell stocks when retail investors collectively decide to buy or sell a significant amount of funds.  But only active fund managers need to navigate the rocky shoals of “discretionary” buying and selling.

A recent study by BIS (a central banking consortium) found that active funds had greater outflows than either index ETFs or index mutual funds in the three most recent bouts of increased volatility (the 2013 “taper tantrum”, various events in 2015, and the 2016 “presidential race turbulence”).  They conclude from these data that index funds can help stabilize markets under many circumstances.

None of this is irrefutable proof that index investors will necessarily behave better than active investors in the next market crash.  However, if the primary concern is that index investors will act like active investors, it’s hard to see what new problem has been created by index funds.  After all, aren’t most of the same folks likely to sell in a panic, regardless of whether they invested in actively managed funds or index funds instead?

Increased Stock Correlations – The third claim about increased volatility is that more indexing is causing higher correlations in stock price movements.  If all stocks decline and rise in near lockstep, that process may widen and deepen each market swing.  Correlations of stock price movements have increased in the last 30 years, which roughly coincides with the rise of index investing.  It’s possible that one reason for this trend is that the same stocks are held in many index funds.  However, I pointed out last year that this trend has at least temporarily reversed in the last 10 years, though most stocks are still pretty highly correlated with each other.

The BIS study I mentioned before and a recent study by the Federal Reserve Bank of Boston both reviewed the literature on the link between index investing and stock correlations.  They both found evidence for higher correlations in stock price movements for the stocks contained within an index, but the BIS study found that price differences between stocks inside and outside an index were actually magnified.  Both studies concluded that the evidence is “mixed” regarding the impact of within-index correlation on broader market shocks.

Inherently Chaotic and Unpredictable

The idea that the rise of index investing is a new situation that’s inherently chaotic and unpredictable comes mostly from a television interview I saw with economics Nobel Laureate Robert Shiller.  Because Professor Shiller was prescient about the 2000 and 2008 crashes, and has a Nobel prize sitting on his shelf, I always pay attention to him.  In the interview, Shiller mentions the price discovery concern, which I showed in my last post appears to misunderstand how index funds work within the larger market and assumes that active investors won’t step in to exploit increasing price distortions.

Shiller goes on to say, that “It’s kind of pseudoscience to think these indexes are perfect, and all I need is some kind of computer model instead of thinking about business.”  Professional investor Cullen Roche has observed these debates, and he uses the S&P 500 index as an example to explain how index funds work in general:

• “[The S&P index is] a rules based portfolio that is determined by the S&P Index Committee that attempts to reflect the large cap segment of the US equity market.  It’s not just a mindless index.  In fact, it has incredibly strict rules that were created by people.”

He goes on to list some of the fundamental business rules that index committees use including market capitalization, liquidity measures, and financial viability measures to name a few.  He then says:

• “These rules are changed at times based on how the committee determines them.  And when a security in the index fails to meet these requirements they are sold off.  Likewise, new additions are determined by new entrants that best reflect the requirement rules.  These rules aren’t just fundamental.  They are strictly fundamental.”

So, it seems misleading to call indices “pseudoscience” or to say that they fail to “think about business”.

Why would a Nobel Laureate in economics ignore these facts about price discovery and how indices work?  I can’t say for sure, but if you look at the topics Shiller has studied the most, they include behavioral finance, how bubbles form, real estate markets, risk management, and analysis of asset pricing.  But I couldn’t find much of anything he’s published that’s directly applicable to the mechanisms and impacts of index funds, as far as I can tell.  Perhaps Shiller understands index funds perfectly, and he’s looking at something deeper that he didn’t explain in this particular interview.

Regardless, in his typically prudent style, Shiller refuses to forecast how the rise of index investing might impact the wider markets.  He instead calls it a “chaotic system” that is essentially unpredictable.  This is probably the most that any honest expert can say about the future of something as complex as the financial markets.  So, he has a concern, but unlike some of the other articles I’ve reviewed, he’s clearly not predicting certain doom for the markets because of index investing.

Indexing Causes Persistently Higher Valuations

Cullen Roche was also my main source for the concern that the rise of indexing is causing persistently higher market valuations.  Because Roche has been extremely critical of most of the scary claims about index investing, his remaining concerns deserve special attention:

• “Over the last 40 years, we’ve seen a persistent creep in market valuations.  Ratios like CAPE or the equity market as a percentage of aggregate financial assets show that investors are increasingly overweight equities, on average.  It’s very likely that index funds put pressure on valuations by implementing overly simplistic investing models that convince people to be more overweight equities than they might be comfortable.”

He later clarifies that it’s not the indices themselves that are “overly simplistic”.  Rather, he seems to be saying that many people simply don’t try to understand important assumptions and implications behind the stock index funds they are buying.

Of course, I think Roche would agree that the simultaneous rise of index investing and valuation measures like CAPE ratios is not by itself proof of cause and effect.  That same Federal Reserve Bank of Boston study reviewed the existing literature on the price effects of stocks being included in an example index and concluded that:

• “Subsequent papers have generally confirmed a short-term price effect of adding a stock to the S&P 500, but there is no consensus in the academic literature on longer-term effects.  Indeed, Patel and Welch (2017) find that stocks no longer experience permanent price increases when they are added to this index.”

So, multiple factors may have contributed to increased valuations, and the extent to which index investing is the primary culprit may be uncertain for many years.

Concentration of Indexed Assets

The last concern is that most indexed assets are concentrated within a few large firms, which introduces a new risk to the markets should one of these firms become financially unstable.  I’ve seen this concern in several places, but the most detailed review that I found was in the same Federal Reserve Bank of Boston study.  They noted that, as of March 2018, 23% of assets under management in all ETFs and mutual funds were in index funds run by a single company (Vanguard).  And the index funds of the top five firms represent nearly half (44%) of all fund assets.  The study concludes that a “significant idiosyncratic event at a very large firm” such as a “cyber-security breach” could lead to redemptions (fund selling) that represent a large part of the entire market, which could precipitate a wider panic.

This is essentially a new kind of “too big to fail” risk that was such a popular topic during the 2008 financial crisis, although the Bank of Boston study doesn’t make that comparison.  To the extent this comparison is valid, it highlights that the cascade of events after a big idiosyncratic event at one firm are highly uncertain.  It’s possible that the government would decide not to intervene, resulting in the eventual failure of a large firm and a huge shock to the wider markets.  However, it seems equally possible that the government would take action to insulate and stabilize the financial world, much as we saw in 2008.  Again, the risk seems reasonable to consider, but that’s a far cry from a firm prediction of an imminent market meltdown.

Conclusions

The simplest and broadest concerns about passive investing, which I discussed in my last post, clearly feel like scary Halloween stories.  They’re mostly a chilling fiction.  However, in this post we’ve discovered some more nuanced and factual concerns about the rise of index investing.

Specifically, it’s plausible that the rise of index investing is causing increased stock volatility due to higher correlations, elevated asset valuations, and some new “too big to fail” risks that didn’t exist before.  But it seems wise to follow the lead of Robert Shiller and conclude: these risks exist, but no one can predict whether or to what extent index investing will drive a catastrophic financial event.

Further, history abounds with speculation about many kinds of perceived dangers (as well as optimistic predictions) that never came to fruition.  It’s just as likely that some completely unexpected chain of events will lead to the biggest future problems.  Perhaps something about index investing will exacerbate the next crash, or perhaps index investing will help minimize other nascent problems that are hidden today.

So, what should we do in the face of these uncertainties?  My conclusion is that mindful investors should stay the course and continue to hold a moderately diversified portfolio containing mostly low-cost stock index funds for two reasons.  One, most of the concerns about passive investing, if they come true at all, envision impacts to entire markets.  None of these concerns offers solid clues about how or where to hide from these market-wide effects.  Two, it’s highly uncertain that these events will occur as predicted or occur at all.  So, pulling all your money out of stock index funds and putting it into something “safe” with a low return (like short-term bonds, gold, certificates of deposit, or your mattress) would certainly diminish your chances of long-term investing success, regardless of whether these potential catastrophes eventually occur or not.

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*Also, the idea that active investors somehow “stabilized” crashes in the past seems a bit puzzling.  Consider the negative 86% return after 1929 or the bear markets that produced returns of about negative 50% in 1937, 1973, 2000, and again in 2007.  Even in 2007, passive investors were a clear minority of the market, so these crashes were all caused by active investors.  I was investing throughout the 2000 and 2007 crashes, and at the time, it felt very much like the more active investors were the least stable and rational participants in the markets.