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FIFTY YEARS AGO, when the first index funds were getting started, critics wasted no time attacking the idea. They called it “un-American” and a “sure path to mediocrity.”
But over time, indexing has grown to the point where it now accounts for more than half of all U.S. mutual fund assets. Last year, research firm Morningstar declared that “index funds have officially won.” But this victory seems to have only increased the level of criticism.
In an interview last year, David Einhorn, a longtime hedge fund manager, argued that markets are “fundamentally broken” and that passive investing—that is, index funds—are the cause. Here’s how he explained it: As more investors go the route of indexing, the result is that more active managers close up shop. That, in turn, means that fewer research analysts are following individual stocks. In Einhorn’s words, there is now, as a result, “complete apathy” in certain parts of the market.
Many smaller companies, Einhorn says, are almost entirely overlooked. “There’s entire segments now… where there’s literally nobody paying any attention.” That’s because the remaining active managers tend to focus their energies on larger companies. Now, even when small companies issue positive news, Einhorn says, their stock prices often don’t react because there aren’t enough investors following them. “These companies could announce almost anything other than a sale of the company and nobody would notice.”
This is a problem, Einhorn says, because he feels it’s caused share prices in many cases to become distorted. The large stocks that dominate the top end of the market—Apple, Amazon, Microsoft and so forth—continue to rise because they’re so visible. But lesser-known companies can see their stocks stagnate even when they’re doing well.
Einhorn quotes a colleague, who liked to say that, “a bargain that remains a bargain is no bargain.” In other words, a growing number of active managers these days are giving up on stock-picking because they worry that they won’t be rewarded even if they do everything right. To the extent that successful stock-picking was always difficult, it’s become even harder. “So what happens is instead of stocks reverting toward value, they actually diverge from value,” he says.
Academics have looked at this question and reached similar conclusions. In a paper titled “How Competitive Is the Stock Market?” a team of researchers confirms that the stock market has fundamentally changed. By examining the trading decisions of institutional investors, they found that investors today exhibit the “apathy” that Einhorn has observed. This is a problem because it means that share prices today are less reflective of companies’ true value.
Versions of this debate have been around for years, with market observers worrying what might happen if, over time, everybody became index fund investors. In theory, under that extreme scenario, stock prices would never change—because there would be no research analysts following the developments at each company, and thus no one would be motivated to bid stock prices up or down. Einhorn’s picture of “literally nobody paying any attention” would be extended to the entire market.
But what if something short of 100% of the market were indexers—what if maybe 90% or 95% of investors chose to index? Would the remaining 5% or 10% be enough for the stock market to remain efficient—that is, to help keep stock prices in line with the profits of their underlying companies?
For years, as index funds have grown, this is how the question has been framed. But in a paper published last year, the economist Owen Lamont argued that this isn’t the right perspective. Whether the market remains efficient doesn’t depend on how many active investors remain. Instead, Lamont says, what matters is which active investors remain.
“If the 50 smartest and best-informed investors switch to passive, then yes, it could make prices less informative.” But, Lamont says, “If the 50 craziest and least informed switch, then maybe market prices get more informative. What matters is who stays in the market.”
That certainly makes sense. Even if just a small number of active investors remain, stock prices could nonetheless remain reasonable, as long as the remaining active investors aren’t the ones who are “the craziest and least informed.”
On this point, one market observer has weighed in with a discouraging observation. Cliff Asness is a longtime hedge fund manager. In a recent paper titled “The Less-Efficient Market Hypothesis,” he argues that the internet—and social media, in particular—have caused the market to become less efficient. In his view, what we’re seeing is indeed closer to the 50 craziest investors taking over active management rather than the 50 smartest and best-informed.
Asness calls the investors who dominate social media today “a coordinated clueless and even dangerous mob.” You’ll recall, for example, the so-called meme stock craze from 2021. A YouTube personality calling himself Roaring Kitty took the lead in driving up the share price of the failing retailer GameStop to irrational levels.
What’s the implication for individual investors? While notable, the GameStop episode was a mostly isolated incident, and the reality is that we don’t know right now which way things will go—whether it will be the “clueless mob” or “the 50 smartest people” who will have more impact on share prices going forward.
If current trends continue, though, one conclusion is that those who continue stock-picking may experience markets that are more volatile and more unpredictable. That’s because, as more active managers exit, a smaller and smaller number of investors will be able to trigger more significant price moves. And because social media gives greater visibility to online personalities like Roaring Kitty, those price movements may be more irrational than they were in the past.
What are the implications for index fund investors? Einhorn’s observation about the ghost-town effect among smaller stocks suggests that broad-market indexes may be relatively more stable—for now. The reality, though, is that no one can say for sure, because the market hasn’t gone through a transition like this before.
It’s also a difficult phenomenon to quantify. There’s no reliable barometer for the level of irrationality in the market. We can point to individual cases like GameStop where prices clearly became irrational. But that was the exception. When, for example, Nvidia shares dropped 17% in one day last week, was that a rational move? It’s an open question.
The bottom line: The market is definitely in the midst of a transition, but the exact contours of this transition are still an open question. In the past, I’ve felt that investors’ best and only defense was to diversify broadly. That may be even more true today.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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‘There’s no reliable barometer for the level of irrationality in the market. We can point to individual cases like GameStop where prices clearly became irrational. But that was the exception. When, for example, Nvidia shares dropped 17% in one day last week, was that a rational move? It’s an open question.’
the dow, the nasdaq are NOT the economy..it’s its proximate temperature….the ole invisible hand is about direction over time, not aberrant anomalies…just as you can affect an oral thermometer by drinking cold water before measuring. goofy crap in the markets like organized speculation, news that makes the herd jump, and of course the rapidity is magnified by traders having very fast machine access to info and a desire to beat the markets!!
we have choices as we have little or no personal control over the vectors of our economy…our only choice is what stream to ‘row, row, row our boats; which waves to surf…i’ll watch the locals, i’ll follow the herd.
Adam said, “In the past, I’ve felt that investors’ best and only defense was to diversify broadly. That may be even more true today.”
I couldn’t agree more and I have a question.
What is more broadly diversified than owning VTI…VXUS…BND…BNDX? And in a more cost favored manner?
Answer…Nothing…and None.
And I have another question.
How many times does the market have to prove that the chances of an active manager beating the S&P 500 is infinitesimal, before “the smart people” learn?
Answer? Who really knows?
Active Managers are nothing but market inters and market timing does not work successfully, over the long term. But that doesn’t stop “the smart people” from trying, does it?
I am retired, 74 years old, 100% VTI/VXUS. My “bonds” are my annuity income, 78% of which is received income tax free.
Happy Retirement folks.
Add to this likely deregulation and crazy things people in power say, things we haven’t thought about yet. Maybe even vilification or elimination of indexing. It’s gonna be a wild ride!
Nice perspective. Thanks, Adam.
I’m no finance expert. But I will offer this. A friend is president of a publicly traded bank. He thinks over the long run, the most important metric is whether the company’s book value is increasing. If so, the stock has to rise. So, wouldn’t any company which increases in real value eventually be discovered by smart investors thereby driving up its value?
Not sure that I agree with the final takeaway. If the point of the article is that indexing has affected pricing in the markets, diversifying within those same markets can’t be a solution. Rather, it’s an extension of the same problem.
But I’m reasonably in favor of Adam’s other implied point. If indexing has created inefficiencies / inaccuracies in pricing, the smart money will figure that out and correct it. Translation – some sharp operators will keep the markets honest and pricing will follow.
I agree with your last paragraph, but I’m going to index invest to take advantage of these smart people. What I’m not going to do is think that some smart active managers are going to beat the markets consistently. The research has shown that trying to find, and bet on such manager’s fund with your money is generally a fool’s errand.
Besides the number of investors needed to keep markets functioning, is the number of dollars. That is, one foundation or hedge fund could have the same effect as many many individual investors as far as the effects discussed in this article.
Its a concern I share as well. Not sure if the amazing number of different sector ETFs and products will help dilute the concentration. I have kept my original stock index funds but more recent purchases have been directed to value sectors in an attempt to offset the risk of high concentration in a few stocks in the capital based index funds.
Not the point of your article, Adam, but a related question: wouldn’t overall market stagnation also depend on the issuance of new shares, the buyback of existing shares, and new money entering the market? Supply and demand?
The crazy thing about indexing is that stocks get owned by the indexes simply because they exist. I’ve seen instances of companies that are frauds in plain sight, yet they were owned by the big firms like Vanguard, Fidelity, Black Rock, etc. because they had to own them. The founder of one of these frauds is still in jail. So, it’s this mindless purchasing of company stock by index funds, regardless of what may be going on at the company, that has always seemed odd to me.
Adam, thanks for a thought-provoking article. Yesterday I had a discussion with my brother, and we talked about the rise of alternative investments. Is it possible that the Alts who provide private credit to the small and middle market replace the analysts of smaller companies? I’m struggling to see how they fit in the investment landscape, and what the future holds?
Asness had a few things to say about this indexing question in an interview with Ted Seides on the Capital Allocators podcast last year. He calls it the Indexing Singularity moment and didn’t seem overly concerned.The topic comes up near the end:
https://www.capitalallocators.com/podcast/simple-investing-is-hard/