Index funds are ruining the stock market

Index funds are ruining the stock market

Index funds are great. They give you broad exposure to the entire stock market, maximum diversification, and minimal costs. Everyone should have their money in index funds, right?

That’s the thinking these days and it has a lot going for it. Low-cost index funds have typically outperformed most “active” funds, where someone tries to pick the best stocks, over time.

But if index funds are great for any individual, what happens when everyone buys them? Does everybody win?

In logic that’s called the fallacy of composition. It may be a crucial question for every investor right now: Especially for the ordinary public.

And it’s touched on in a new research paper written by finance professors Hao Jiang of Michigan State University, Dimitri Vayanos of the London School of Economics and Lu Zheng of UC Irvine.

They argue that the popularity of index funds is helping cause one of Wall Street’s most dangerous features: The massive overconcentration of the S&P 500 (and the market) into a few megacap stocks like Apple Nvidia and Microsoft

The numbers regarding index funds are amazing. “In 1993,” they write, “passive funds [i.e. index funds] invested in U.S. stocks managed $23 billion of assets. That was 3.7% of the combined assets managed by active and passive funds, and 0.44% of the U.S. stock market. By 2021, passive assets had risen to $8.4 trillion. That was 53% of combined active and passive, and 16% of the stock market.”

From 3.7% of mutual fund money to 53% in 30 years.

Actually, the real change is even greater than that, they add. That’s because many or most of the remaining “active” U.S. mutual funds, meaning the ones who are still trying to pick stocks, are becoming closet indexers. They are shadowing the indexes as closely as possible. “The growth of passive investing has been estimated to be more than twice as high when accounting for the increasing tendency by active funds and other investors to stay close to their benchmark indexes,” they write.

This trend is accelerating the rise of what they call “megacap” firms, especially those likely to be “overvalued” — or at least ambitiously priced.

“Flows into passive funds raise disproportionately the stock prices of the economy’s largest firms, and especially those large firms that the market overvalues,” they write. Among the reasons is that it reduces the potential pool of active investors who can hold less than the market weighting in the stocks, and the potential pool who can actually sell it “short,” which means taking an outright negative bet on the stock.

Even if you don’t go that far, it’s obvious that index funds — by definition — must invest the most dollars in the stocks that are already the biggest in the index, and therefore the most popular.

At this point, the so-called “Magnificent Six” — Tesla seems to have vanished from the list — alone account for about one third of the entire S&P 500 by assets. If you hold $100 in an S&P 500 index fund, about $32 is invested in just six companies. How’s that for diversified?

All of this makes the S&P 500 today more of a short-term trading game than a long-term investing game. As the S&P 500 rises, more people will throw money into index funds. The index funds will throw their money into the stocks, with most going into the megacaps. The stocks will rise, other people will get excited by all the money their neighbors are making, and they will rush out and throw their money into index funds too.

“High prices bring out the buyers,” as fund company Leuthold Group notes dryly in its latest monthly research book. Leuthold notes that even while U.S. consumer expectations for the U.S. economy are depressed, their expectations for stock market returns have “scarcely

been brighter.” This, at a time when the S&P 500 is trading at levels, in relation to various earnings measures, associated with previous peaks such as 2021 — and even 2000.

This isn’t necessarily an argument for selling your S&P 500 index fund: Timing these things is notoriously difficult. But it is an argument for owning midcap and small-cap stock funds, for instance those tracking the S&P 400 mid cap index and the S&P 600 small cap index, as well as one that follows the S&P 500. Or you could do what I do, and just invest in one that owns an equal amount of each stock. Low-cost funds that do that include the Invesco S&P 500 Equal Weight ETF which charges 0.2% a year, and the iShares MSCI U.S.A. Equal Weight ETF which charges 0.09%.