What happens when index funds eat the market?

I’ll preface this by saying, I employ primarily index ETFs for my clients as they offer diversified exposure to asset classes at a minimal cost. That said, it is interesting to consider the larger market effects of the ever larger move towards indexed investments.

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Though indexed strategies have been around since the late seventies, their popularity has boomed since 2008, and they currently make up 29% of US markets, and that share is only expected to grow over the next decade. As you can see from the chart above, index funds have been gaining hundreds of billions of dollars each year. This growth begs the question of what effects large scaled indexing has on individual stocks and the markets in general.

The majority of the money held by index funds tracks ‘dumb’ indexes, or indexes that include stocks purely by market cap or some other rudimentary metric. This means most large US companies are held by the lions share of index funds. In an environment where assets are moving into index funds, these companies experience ongoing buying from the index funds regardless of fundamentals, financial performance etc. As Seth Klarman notes this process could create inflated valuations for companies of less than stellar quality, and when that happens the stock market’s ability to determine the intrinsic value of a company is diminished. Or said another way index fund growth is reducing the informational efficiency of the markets.

Why does that matter? you might ask. It reduces the value of owning quality companies, both when asset flows are pouring into index funds, and when they are pouring out (a more concerning problem). When assets flow into index funds en masse, the index funds work like a rising tide, lifting all stocks (all stocks commonly held by index funds). When the asset flows reverse, however, the exodus from index funds acts as a drag on all commonly owned stocks regardless of their quality. In short, it makes owning individual stocks yet more uncertain and subject to the whims of broader asset flows. For index investors it means less, but it could mean that valuations are getting stretched by the non-evidence based buying index funds engage in.

In the end, I don’t think this information is going to change the decision making of most investors, but advisors should be cognizant the potential risks for index funds are still not fully understood.

Nathan

 

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