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CRITICS OF INDEX FUNDS are pursuing a new line of attack. Passive investing, they argue, is distorting market prices and creating an unhealthy bubble.
To be sure, the market today is expensive. The price-to-earnings (P/E) ratio of the S&P 500 stands at about 22. That’s substantially above its long-term average of about 16. Of more concern, that metric is approaching a level not seen since the market peak in 2000, just before stocks dropped 57%.
The concern today is that the market is similarly skating on thin ice, and some feel that index funds are the proximate cause. Here’s how a recent writeup in The Atlantic presented the argument: “A market dominated by passive investors naturally becomes more concentrated… Because they allocate funds based on the existing size of companies, they end up buying a disproportionate share of the biggest stocks, causing the value of those stocks to rise even more…”
To support this argument, critics note that the so-called Magnificent Seven technology stocks are now valued at more than $1 trillion each. Nvidia alone is worth more than $4 trillion. To put that in perspective, Nvidia is worth more than the smallest 235 companies in the S&P 500 combined.
In an effort to pin the blame on index funds, The Atlantic explains how actively-managed—that is, non-index—funds operate. Traditional funds are “highly sensitive to company fundamentals and broader economic conditions.” The managers of these funds “pore over earnings reports, scrutinize company finances, and analyze market trends…”
In other words, according to this argument, traditional active managers do more to keep markets healthy. Index funds, on the other hand, are presented as an unhealthy influence because they buy stocks robotically and sell them only infrequently. And since index funds have been steadily gaining market share, the implication is that they are responsible for driving prices to irrationally high levels.
Should we be concerned? In my view, there’s a kernel of truth to some of these arguments, but I’m not sure they’re entirely accurate.
Let’s start with The Atlantic’s first point: It argues that index funds are creating unhealthy market concentration because they allocate funds “disproportionately” to the largest stocks. The logical flaw here is that index funds actually do the opposite: They allocate money proportionately. If Amazon, for example, represents 4% of the S&P 500, then $4 out of every $100 invested in an S&P 500 index fund will be allocated to Amazon. Index funds, in other words, are an entirely neutral factor in the market.
Index fund critics also fret about the fact that there are fewer public companies today than there were 25 years ago. The implication, according to this argument, is that more dollars are chasing fewer stocks, thus further driving prices up. That sounds like a valid argument, but it ignores an important reality: Companies today are so much larger and more profitable than in the past that the aggregate value of public companies is, as a result, much larger. Apple and Nvidia, for example, each earn about $100 billion per year. So the fact that there is a smaller number of public companies today is more of a side point and not really relevant.
Critics of index funds also confuse correlation and causation. The reality is that this isn’t the first time that market valuations have risen. At many points in the past, stocks have been even more expensive than they are today. During the 1990s, for example, when valuations rose dramatically, index funds represented less than 10% of mutual fund dollars. Looking back further, index funds didn’t even exist before the 1970s, and yet market bubbles have occurred throughout history. The market might be high today, but it’s ahistorical to say that index funds are the cause.
For these reasons, I don’t think we can blame index funds for today’s share prices, and I still think they’re the best way to invest. That said, investors should always keep an eye on risk. As the end of the year approaches, it’s a good time to conduct a portfolio audit. Here are some steps I recommend:
First, review your asset allocation. As I’ve noted in the past, I suggest asking three questions: How much risk do I need to take? How much risk can I afford to take? And how much risk am I comfortable taking? An alternative you might consider is the popular “bucket system.” Either way, you want to set aside sufficient dollars outside the stock market to carry you through a market downturn, if that’s the way things go.
Then, look to diversify within the stock portion of your portfolio. Owning just the S&P 500 has been a winning formula for many years, but in light of today’s market concentration and valuation, it makes sense to diversify into smaller stocks, into value stocks and into international stocks.
Another strategy would be to own a fund tracking the S&P 500 Equal Weight Index. As its name suggests, this version of the S&P 500 holds each of the 500 stocks in equal amounts—about 0.2% each. Result: The Magnificent Seven as a group would hold just a 1.4% weighting—far less than their 35% weight in the standard index. This isn’t my preferred approach because it can be tax-inefficient, and equal-weight funds are a bit expensive. But it’s worth considering.
A final point: While I suggest taking precautions with your portfolio, I don’t mean to unnecessarily sound the alarm. Even though stocks are expensive today, that doesn’t necessarily mean that they have to drop. We should always be prepared in case they do. But the market could also return to Earth in a much more gradual fashion. If corporate earnings were to grow over the next five or so years at their historical average rate of about 7%, then the market’s P/E ratio would naturally drop back to a normal level without any sort of dramatic or unpleasant market downturn. Investors, in other words, should take precautions but shouldn’t panic.
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.
The real question is where is all the money coming from? New cash comes into the stock market every month, so of course prices are going to be much higher whether index investing exists or not.
Income inequality and huge Federal deficits are creating a very unbalanced economy. The top 20% can afford to spend less than they earn, and build up huge wealth without touching it. This holds down the inflation that would otherwise occur – the inflation in the real economy, that is. The inflation in stock prices? Well, everything is great as long as the affluent people don’t need money for spending.
“..according to this argument, traditional active managers do more to keep markets healthy..”
You have to laugh when you read this sort of logic. So, if I pay 1.0-1.5% (or more) in management fees, I’m going to get better performance because markets are healthier?? So far, research provides a resounding “no” to that question.
I spent my career in the investment business and there were a lot of good things that the fees we charged paid for (client service, estate planning and settlement services, tax advice, etc.), but superior investment performance was seldom one of the outcomes.
Given the ease of using index funds with their low cost and generally better performance over time, it’s hard to see why someone would not use them, especially given the fact that the average investor tends to be pretty clueless when it comes to managing their own money.
The argument that index funds are harmful to markets has been around for years and maybe someday, someone will be able to demonstrate this to be true, but in the meantime, its hard to argue against the fact that index funds have provided an accessible means to achieve better investment returns at a lower cost.
Excellent!
Thanks
Because the S&P500 and total market funds are top heavy and because if the market crashes, dividends will continue to be reinvested at lower prices, I moved about a third of the total market allocation to SCHD. This is in a Roth, so there are no tax issues. Let’s check back in a few years…
As for the question whether index funds are inflating the market, I think not. I think a fair question is whether such a flood of retirement money is inflating the market. This may be likely. It is a steady stream of cash into the market.
Thanks Adam. I agree that arguments blaming index funds for any distortion in valuations are pretty weak.
I have heard the counter argument (maybe from Ben Carlson?) that only a relatively small proportion of actively managed money is required for price discovery. And my thinking is that there will always be enough investors / funds that will seek to invest actively to meet this price discovery need.
I’ve recently moved 2/3 of our investable $ to a money mgmt. firm that I’ve assiduously followed for 28 years. Being risk averse, has resulted in my less than stellar performance, but I have avoided the gut wrenching downturns and sleep well. My better half has NO interest in managing assets so as we approach our 8th decade, it is a far, far better thing that I have done. (Trading commodity futures in the ’80s taught me how to make a small fortune…e.g. start with a large fortune)
You are wise to acknowledge the fact that your spouse, like mine, will not take over managing your assets after you are gone, or still here but unable to continue. Hiring a good manager, when its time, seems like a smart move.
This is an important subject that reappears periodically. I personally have a diversified portfolio of index funds and a 50:50 mix stocks and bonds, because at my age I am concerned about sequence of return risks and have a plan that can weather a prolonged winter in the stock market.
Specifically on the notion of “index funds creating a bubble” Ben Carlson wrote a complimentary article in 2019. The article indicates that the indexing naysayers had the knives out about index funds creating a bubble back in the 1990’s and I understand from reading elsewhere from the inception of index funds. Ben’s article goes into detail debunking this myth. Here is link to the article:
https://awealthofcommonsense.com/2019/09/debunking-the-silly-passive-is-a-bubble-myth/
Yep, diversify, diversify, diversify. Here it’s easy: research AVGE and you are covered worldwide in one fund of funds ETF. There, now you know. Let the beatings begin! 😆
Adam,
I am glad you mentioned the bucket approach. It is very appropriate for those who are retired and cannot have so much in stocks that they would be in a difficult position for a long time if they had to “wait” for a major market recovery.
Bill
Another good article. I have long been a strong believer in the S&P 500, I am also a fan of Buffett who recommends like 80/20. I am nearing 80 years old, and my goal is 85% S&P and 15% Cash, yes you heard that right. The cash is to pay the bills when the stock market goes South. As for equal weight, it earned 25% less than the S&P over the last 10 years! I am currently overweight in Mag 7, due to the fact as an Electronic Engineer, I have been a BIG believer in Electronics and Software. Thanks Adam for bringing out the most truth about stocks as best as practical.
A kindred spirit! I’ve known several insurance company officers over the years, and they were concentrated in – insurance company stock. That makes sense because they probably know what is going on in the insurance business, like you do in the electronics area.
Maybe someday there could be too many passive investors, but the metric shouldn’t be proportion of the market _owned_, but the proportion of _trades_.
Passive investors trade many times less frequently, so active investors are still disproportionately doing price discovery (which does the price discovery we so happily leech off).
If inefficiencies are systematically introduced by passive investors, eventually the so-shrewd shrewd active players will eat our lunch. For a season, anyway. And then, shocker, the problem would be solved, and passive would be efficient again. Without us lifting a finger. Rinse and repeat.
The fretting is much too early.
Thank you for two important reminders: First, consider whether one has the capacitance for, the need, and finally the tolerance of risk in their investing, in that order. Secondly, a precipitous drop in stock prices creating a buying opportunity could be coming. But an alternative scenario, such as an extended period of price stagnation leading to a gradual reduction of the P/E is possible.
If I were young and retirement was far off in the future, my priority would be long term growth, so I would own mainly stocks, and I would keep dollar cost averaging into a mix of domestic and international stock index based funds. But I am in my eighth year of retirement so my priorities have shifted. I wish to mitigate the sequence of returns risk and ensure that I will have a stable funding source for future withdrawals, along with a healthy allocation to stocks for long term growth.
Taking your principles into account, along with my “sleeping point”, I have gradually shifted my stock/bond allocation from 75/25 to 50/50. Thanks for another helpful article, Adam.
I like to pose the “risk” question to people this way. (1) How would you feel if your investments went down 50%? (2) How would you feel if your IRA account statements showed that the $1,000,000 you had saved over a lifetime was now worth $500,000?
It changes the perspective a bit.
I agree with you. And my answer to that important question was to downshift from 75/25 to 50/50. A 50% cash and short- term treasury allocation means I can continue to meet my annual cash needs and can wait, if necessary up to 16 years for stock price recovery. Although, more realistically, I would likely buy more stocks if they went on sale, but being careful to hold 10 years worth of future withdrawals in cash and treasurys.
The answer to the question of how much to hold in stocks, supposedly from JP Morgan was to sell down to the sleeping point. I reframed the question”how many years worth of future withdrawals do you need to have in something secure, like cash and short term treasurys, to sleep at night? Now this is where many reasonable and smart folks on this site may differ. It probably depends in part on where we are in the life cycle, and on our goals. For me, in this current market, my future withdrawals are covered until age 88 (!!). Some say 5 years. Depends on whom you ask.
Nah, because you are not supposed to be 100% in stocks unless you are 20 years old. Thus, the formula 120 minus your age equals the % in equities. The other allocation is up to you, either in crypto, commodities, bonds, money market, or precious metals. The % allocation to those is up to you.
Just a few days ago I did a comparison between S&P 500 market-cap weighted index funds and S&P 500 equal weight index funds thinking that I could reduce the concentration risks that everyone seems to be talking about these days.
I was surprised to find that the equal weight strategy did not reduce volatility at all. Looking back as far 2002 the equal weight index was negative in 5 of 21 years and the market cap index was negative in 3 of 21 years. Only in 2022 did the equal weight index lose less than the market cap index. Most telling was that in 2008 the equal weight index dropped about 40% compared with market cap index’s 37%.
And, not surprisingly, the equal-weight 10-year return was only 74% of the market-cap index fund return.
So as far as I can discern there does not seem to be any benefit to investing in an S&P 500 equal weight index fund.
what is your purpose?
that kind of question that should precede the risk profile… my purpose is a good night’s sleep so i embrace the illusion of balance to minimize both risk and the necessity of moment by moment attention.
i bought a popeil set it and forget it rotisserie oven. when i unboxed it the inner box said in very large letters ‘don’t take set it and forget it literally’.
my purpose accepts that premise. i thought of a number where i ‘felt’ safe to be liquid…i doubled it. that’s cash…, when i feel unsafe to be liquid i’ll dollar cost back in…that goes with my purpose. slow, stupid, dopey, stodgy.
if i sincerely wanted to be wealthier (not my purpose) and was risk tolerant and felt lucky, blessed, somehow superior i’d go to vegas and put it all on red ;->.
many of the people that say indexing is ‘the problem’ have only the solution of active management….they maybe identifying a problem but offer no real solutions….scratch that..they DO offer a solution according to THEIR purpose. taking your money….
Thanks Adam. Another thought provoking article to kick off the weekend. I tend to agree that simply blaming index or passive investing for the current level of stock valuations is an oversimplication. For starters, there are many more indices than just the S&P 500, including the Russell 2000 which is also quite popular. Is it possible that we simply have more dollars chasing fewer stocks? I think it is safe to say that many more households are investing in equities today than ever before. It is also true that we have less publicly traded equities. Simple economics suggest that demand is greater than supply causing prices to go up. Another factor is that many of those dollars flowing in are set to autopilot and thereby ignore the level of valuations. Target date funds and advisor allocation models simply take incoming funds and allocate them according to a set formula. Personally I think the combination of more dollars set to automatically invest in some combination of fewer stocks requires us to question whether a historic 16 p/e is still the right metric.
As soon as I saw it was The Atlantic bashing index funds. I stopped reading thanks Adam.
My thought too.
I’m glad Adam had the stomach to read through its … stuff.
I thought the same thing. I doubt even Warren Buffett reads the Atlantic for investment perspective.