Most of us can think back to our childhoods and remember a time when we ate too much ice-cream, or raw cake mix, that turned the moment from feeling wonderful to feeling sick. In the investment world, the invention of the index fund (i.e. a fund that closely tracks a defined market index), was a moment when investors were handed a big bowl of index-flavoured ice-cream. It is amusing to know that some in the US even declared index funds as ‘un-American’ as they were not trying to beat the market!
Since the 1970s index funds have proven themselves to be an essential part of the investment armory of any sensible investor, delivering cheap, well-diversified, easy-to-pick, market-like returns for investors. We know from many studies that the vast majority of actively managed funds i.e. those trying to pick stocks and time markets fail to deliver on their promises to do so. One such reputable study is the ongoing SPIVA® report[1]. The US year-end 2023 report reveals that 97% of all US equity funds failed to fulfill their promise to outperform the market over 20 years. Yum! That index-flavoured ice-cream tastes good!
Is there a point at which you can have too much of a good thing when it comes to index investing? That is a valid question. The concern sometimes raised is that indexing relies on securities prices reflecting all known, public information in a timely manner. In other words, markets being pretty ‘efficient’. For this to happen, active investors need to play a material role in this price discovery, by incorporating their research, analysis and interpretation of information into prices they are willing to trade at.
If one extrapolates the level of index investing versus active investing ad absurdum, i.e. to the point that one day everyone indexes, then there would be no price discovery. As John C Bogle, the grandfather of index mutual funds and founder Vanguard, once stated:
‘What happens when everybody indexes?…Chaos, chaos without limit. You can’t buy or sell, there is no liquidity, there is no market.’
John Bogle, as quoted by Jason Zweig[2]
The big question is at what point do markets become less efficient and fail to function properly due to inadequate price discovery? John Bogle sensed that that point is far off. His logic was that perhaps 90% indexed and only 10% active would be such a point, as index funds only account for 5% to 10% of daily trading volumes[3] meaning that the remaining 90% of trades in a day are executed by active managers participating in price discovery. Even if 90% of total assets were indexed that would mean that on a daily basis 50% of all trades will still be made by active managers engaged in price discovery.
Should we be feeling sick yet?
The 100% end-point suggested is unlikely ever to occur because once markets begin to become inefficient, easier profit opportunities will exist, encouraging more active managers to re-enter the fray. This provides a natural mechanism to redress any imbalance.
So how far into the index-flavoured ice-cream bowl are we? According to the US’s Investment Company Institute Factbook 2023[4], at the end of 2022 index funds represented around 45% of the mutual fund market (traditional mutual funds 25%, ETFs 20%) up from 22% in 2012.
The challenge is that whilst mutual fund data are readily available, they only own around one third of US equities. There are several other key players in the indexing space, ranging from institutions such as pension funds and insurance companies to endowments and other not-for-profits, some of whom who may use indexing to some degree outside of mutual funds. This may be in a separately managed accounts managed by index houses or in-house index management. Their exposure to indexed assets is hard to evaluate.
An innovative new study came up with a novel way of estimating how much of the US market is indexed across all of these categories:
A market index, such as the FTSE 100 Index, has a reconstitution date, known in advance, when new stocks are added or subtracted from the index according to the index’s specific rules. An index fund wants to track the market as closely as possible and so will tend to buy the company’s shares on the reconstitution date. The trading volumes spike on those days. The question the study sought to answer was:
How much money would have to be tracking that index to explain the enormous burst in closing volume on reconstitution day that we observe in the data?
In short, there finding suggest a lower bound of 33% and probably closer to 40% of the market is indexed. Based on John Bogle’s estimate of 90%, this is not an issue.
Keep spooning in that index investment flavoured ice-cream!
References
- See: spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2023.pdf
- Jason Zweig, Aug 26, 2016, Are Index Funds Eating the World? Even the father of passive investing has warned of the potential for ‘chaos’ if index funds get too popular. wsj.com
- Vanguard as quoted in Swedroe, L. (2016), Passive investing won’t break markets. 6 Sept. 2016 etf.com
- https://www.icifactbook.org/
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