The performance of actively managed equity funds has consistently failed to lure investors away from low-cost passive strategies. This is hardly surprising, given that roughly 90% of active funds underperform their benchmark index over the long term.
But, of course, it can’t be the strategy’s fault. No, the market itself must be the issue.
Some commentators in the finance world now argue that the growing popularity of index-based strategies is destabilising markets. They claim this influx of assets is inflating a bubble destined to burst. Which will leave everyone naïve enough to believe that investing should be cheap and easy, licking their wounds.
This is a convenient counter to the fact that the majority of actively managed funds have been detrimental to their clients’ account balances when compared to the returns of a reference index.
So, what is their argument, and does it have any merit?
For a background on active vs index investing, read this article. For the purpose of this article, active management will consist of actively managed funds, as well as those people or institutions buying individual shares.
The Arguments
The idea of an index bubble is not new, as evidenced by a letter to the editor of the Wall Street Journal in 1975:
However, since then, the democratisation of financial markets coupled with advances in technology has vastly increased market efficiency to levels unimaginable 50 years ago.
Yet, despite this progress, the same arguments persist.
Index Funds Distort the Market
Critics claim that index funds distort markets by disproportionately directing capital to the largest companies in an index, driving up their prices regardless of fundamentals.
For example, even if Apple were to report dismal quarterly sales, its stock price might still rise simply because more people are purchasing index funds that include Apple as a key component. As the largest company in many indices, Apple would automatically receive more inflows, regardless of its actual performance.
This reasoning suggests that large companies could become increasingly overvalued, while smaller companies outside the index remain undervalued due to receiving less investment.
No More Price Discovery
A related argument is that as assets in passive strategies grow, markets might lose their ability to function efficiently.
A stock market is simply an information processing system. Each trade reflects a different viewpoint: the buyer believes the stock is undervalued, while the seller believes the opposite. When hundreds of millions of such transactions occur daily, the final prices of stocks should reflect the collective interpretation of all publicly available information, a concept known as market efficiency.
The theory goes that indexing disrupts this equilibrium. Buyers of index funds do not evaluate individual stocks; they are indifferent to the price or fundamentals of the underlying companies. Instead, they purchase shares of all the stocks in the index in fixed proportions, introducing no independent judgment into the market.
Active fund managers, on the other hand, analyse individual companies and make trades based on their assessments. This active trading ensures that stock prices align with the fundamentals of the underlying businesses, keeping the market efficient.
The crux of the “index bubble” argument is this: index investors rely on the assumption that markets are efficient, but market efficiency is only possible if active managers continue to trade and embed their analysis into stock prices. If active management diminishes markets may become less efficient, leading to stock prices that deviate wildly from their intrinsic values.
Why They Can Be Ignored
Each of the above arguments, whilst compelling, does not have any basis in fact. This is why:
Index Funds are Free Riders
Index funds primarily follow a buy-and-hold strategy, with only occasional trades when the composition of an index changes.
This is crucial, because it is not important how much money gets invested in a stock, rather the amount that stock is traded. And compared to active management, index fund trading constitutes a fraction of total daily trading volume.
Each time a share trades, again, both the buyer and the seller believe they are getting a good deal. The more trades, the more opinions, the more efficient the market will be. So, it is trading that sets the price, not the amount of new money entering the market.
For example, an index fund might purchase 100 shares of Apple in a day. In contrast, a single high-frequency trading (HFT) firm could buy and sell tens of thousands of Apple shares in the same period.
Research from Vanguard found that whilst index strategies make up over half of the market valuation, they only account for around 5% of total trading volume. This means that the other 95% of trades are made by active management. All of whom are imbuing their opinion into the price of each stock.
It is actually trading volume, not the flow of money into index funds, that drives price discovery. Index funds get to “free ride” on this mechanism, but their relatively low trading activity means they aren’t disrupting the process. Active managers are and will remain the primary force behind market efficiency.
Even as index funds grow in size, there is no realistic scenario where they will account for the majority of trading volume. Active management will continue to determine stock prices, regardless of how much capital index funds hold.
The Market Self-Corrects
Let’s assume for a moment that index funds did somehow distort market valuations, pushing certain stocks above or below their fair value. Such a scenario would actually be an active manager’s dream.
In a truly inefficient market, active managers would thrive. Overpriced stocks would be shorted, and undervalued stocks would be bought up, correcting any distortions and generating outsized returns for active investors. As a result, capital would flow back from index funds toward active management.
In reality though, this hypothetical scenario is unlikely to ever occur. Index funds have been around for over half a century, and the market dynamics have remained stable. Some active funds occasionally outperform, but the majority do not. Meanwhile, index funds continue to benefit from the liquidity and price discovery provided by active managers.
The status quo where active managers dominate trading, while index funds quietly reap the benefits, is likely to continue.
Summary
There is little empirical evidence for the idea of an ‘index investing bubble’.
If index funds were ever to dominate daily trading volume to the point of creating market inefficiencies, active managers would exploit those inefficiencies. This would lead to index funds underperforming, prompting capital to flow back into active strategies and restoring balance.
The share market functions as an information-processing machine. Any inefficiency that arises is swiftly identified and corrected by high-powered trading systems, which profit from restoring equilibrium.
The arguments for an index fund bubble seem to stem from those with a verifiable conflict of interest in the matter – usually people who run actively managed investment firms. Without proper academic research to substantiate these claims, they amount to little more than fearmongering: essentially, “Keep investing in actively managed funds, or else”. Ironically, those peddling the index bubble myth are the exact people who would benefit from an inefficient market.
