Are index funds growing too quickly?

The finance community has been fiercely debating this question over the past few years. They worry that too much money is flowing into index funds, with less and less money being invested in active funds. If index funds become too big, some say that the market will not be able to accurately price stocks. Even Vanguard founder Jack Bogle recently said in a recent interview that

If everybody indexed, the only word you could use is chaos, catastrophe. – Jack Bogle

In my opinion, this concern is completely overblown. We are so far away from the point where index fund investing could distort the ability of the market to correctly price stocks and other securities.

Who said there was no such thing as a free lunch?

Index fund investing represents one of the few free lunches available to investors. By buying into a wide swath of the market using a single index fund, we tap into the collective wisdom of the market, a group of millions of investors all trying to squeeze out a few extra percentage points of return. These investors, both professionals and amateurs, work so hard and spend so much time and money to accurately price the market. Index fund investors reap the benefits of active investors’ efforts.

Betting on the Super Bowl

Anyone who has even a passing interest in sports is familiar with how sports betting works. For example, Super Bowl LI had the New England Patriots playing the Atlanta Falcons. The betting line was New England -3, which means that if you bet on New England, you would win the bet if New England won by 4 or more points, and lose if Atlanta won or New England won by 2 or fewer points. (Your money would be returned if New England had won by 3).

The New England -3 betting line attracted millions of dollars of money in the two weeks leading up to the Super Bowl. As professional and amateur sports bettors placed their bets, the sportsbooks adjusted their odds accordingly. If the betting line was exactly correct for every football game, it would be impossible to make money in the long run. Sportsbooks usually take a 10% vig, or commission, on all bets.

Wall Street is like one giant sportsbook

What does this have to do with financial markets? Wall Street is like one giant casino sportsbook. Professional and amateur investors alike are placing bets on individual stocks. There are professional market makers (like the sportsbooks) who organize all of the buyers and sellers and make a few pennies (or less) by matching buyers and sellers (via the bid-ask spread).

As in Vegas, if the market has perfectly priced a security, you cannot win (get above-market risk-adjusted returns). With millions of active investors, most academics believe that the market is correctly pricing securities and you cannot consistently beat an index fund portfolio. However, with the rapid decline of active investing in favor of passive index fund investing, the question becomes: how many investors are needed to create an efficient market?

The typical NASDAQ stock has 14 market makers, and the NASDAQ has over 500 market makers. Remember that market makers are in the business of making money. They are usually right, or they don’t continue working as market makers for very long. They will quickly go out of business if they aren’t good at pricing the market. Unlike active mutual funds, market makers don’t get paid an asset management fee whether or not they make money for their clients.

The market makers aren’t alone in pricing stocks. They are guided by hundreds of thousands of professional investors and millions of amateur investors. The concern is that as money rapidly flows into index funds, there will be fewer and fewer active investors moving markets to the correct price.

How many active investors does the stock market really need?

Going back to our sports betting example, how many bookmakers are needed to make the correct odds for the Super Bowl? 5? 50? 500? 5000? Once the odds are properly made, it becomes impossible to beat the bookmakers. Right now, there are probably a million bookmakers (actively managed mutual funds / traders / hedge funds) in the stock market. The number is declining because money is rapidly going out of actively managed mutual funds and into index funds, but I believe we still have way more active investors than necessary to correctly price the market.

Conclusion

There has been a massive influx into index funds, and for good reason. It’s one of the few free lunches in life. Because there is so much money to be made in the financial markets, it doesn’t take hundreds of thousands of professional investors to accurately price the stock market. In short, I think there is a surplus of professional investors who make their living investing other people’s money. Like any labor market where there is a surplus of available workers, there either needs to be fewer professional investors or they need to work for less money (i.e. lower expense ratios).

As Warren Buffett said in his 2016 annual letter, one of many great quotes,

A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. – Warren Buffett

What do you think? Is money flowing too quickly into index funds? Will there be fewer active fund managers over time?

12 COMMENTS

  1. I have read the articles too. Not sure if there is too much money in index funds, but my understanding of how these things works. Still, I figure if the market tanks, the cost of other things will likely tank with it. Since I am not 5 years or even 10 years from retirement, I suspect I can bounce back over the following 10 to 15 years.

  2. I think were a long way from too much money in index funds. Especially when they define index funds broadly. The percentage is alot lower when you talk s and p 500. On top of that if it goes to far some enterprising active trator will make millions and then you’ll see a reversal in trend back to equilibrium.

  3. The sports book analogy is interesting to me because imagine what would happen if the line adjusted as the game was played. And then imagine if the game never ended.
    There would always be new people coming in thinking they can figure out the next score or next big play. It seems to me there only need be enough players on each side to keep the game going. It could be 2 or 200. It doesn’t seem like we need too many to affect big change.
    Haven’t there been instances of a few hundred thousand shares trading hands and affecting a stocks valuation by billions of dollars? A relative few people could make big changes.
    As index investors we are playing with the house. We take the vig(dividends) and don’t pay any significant costs to the market makers. It is as close as individuals can come to being the house.
    I think the more important thing to consider is long term whether money is coming in or flowing out. That will detirmine the overall direction and thankfully the US economy has continued to grow and the market has grown with it.

    Tom @ HIP

  4. I like High Income Parent’s above analogy that index investing is an individual investors way of playing the house. I think many Fund companies will go out of business if they aren’t able to adapt and switch over to a tighter business model housing mainly low cost index funds. I would think that not as many workers will be needed in the financial sector in the future.

  5. I don’t think there’s “too much” money in index funds. I think investors have just woken up to the facts that:

    1. most fund managers are terrible investors
    2. few people are good at picking stocks over the long run.

  6. This is a great post! Curious what your thoughts are if there was such a thing as too much money put into index funds? I realize that this is likely a theoretical exercise, but what would be the vulnerabilities / exposures to the index fund investor, and what might be the trades be on the other side?

    • The concern would be that if there was too much money in index funds, the stock market would cease to become efficient. Actively managed mutual funds could then beat the stock market. The question is whether they can beat the stock market by a large enough margin to justify their fees.

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