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April 11, 2015

Index Funds: How Much Is Too Much?

Is there too much money going into index funds?
This is a common question I have heard raised at conferences and other industry events. It’s being raised because of the growth of Vanguard and, secondarily, the growth of exchange-traded funds (the overwhelming majority of which are index funds.)
A common line of thought is that as more money flows to funds following market-cap-weighted indexes, the indexes themselves will have more influence over the valuation of companies. Since most widely followed indexes assign greater weights to some companies than others, the most popular companies see their valuations rise as dollars flow into index funds. A second (and related) argument is the potential for more inefficient pricing of stocks, particularly those with smaller or no weighting in the most widely followed indexes. This mispricing would create opportunities for active stock pickers, while those investors tied to the indexes would miss out on the opportunity for higher returns. There are other arguments against the growth of indexing—including how the indexes are constructed—but the majority fall into the “influence” or “greater inefficiency” camps.
The growth of indexing cannot be underestimated. Four of the five largest funds listed in our 2015 Mutual Fund Guide are Vanguard funds: Total Stock Index (VTSMX), S&P 500 Index (VFINX), Total Bond Index (VBMFX) and Total International Stock Index (VGTSX). Combined, these four funds alone control more than $850 billion in assets. To put this number in context, these four funds manage more assets in dollar terms than the next 10 largest mutual funds combined do.

A skewing toward the most widely followed indexes also exists in the exchange-traded fund (ETF) industry. The SPDR S&P 500’s (SPY) assets under management of $181 billion are more than double those of the second-largest ETF, the iShares Core S&P 500 (IVV). Notice that the largest and second-largest ETFs both follow the same market-cap-weighted index.
As large as these numbers seem, indexing still accounts for a small share of the overall investment bucket. In his latest Intelligent Investor column, Jason Zweig cited data from Empirical Research Partner estimating indexing’s share of the total value of the U.S. stock market at just 11.5%. The number should not be surprising when the bigger picture is considered. While Vanguard is a mutual fund giant, institutional investors (e.g., pension funds, endowments, insurance companies, etc.) have huge portfolios and use tailored strategies based on their specific short-term needs and long-term goals.
Where indexing has made big inroads is among individual investors. While this is not a favorable trend for companies relying on higher fees from active management, it is a good trend for individual investors. A dollar not spent on fund fees is an extra dollar of wealth maintained for future growth. The downside of indexing is not its influence over the market, but rather the returns of the market. A properly designed index fund will never beat the index it is designed to follow. To do better than the index, an investor has to follow an active strategy. (Tactical approaches for determining when to get in or out of in index fund are still active approaches; they simply use passive investments as the vehicles for carrying out the strategies.)
Active approaches are not without downsides either. The majority of active strategies fail to beat their index benchmarks over the longer term. Even if indexing were to further grow considerably in size, the active strategy obstacles of costs, proper implementation, size (meaning too much money trying to follow the same strategy) and discipline would continue to exist.
There will always be a role for both index (“passive”) and active strategies. Indexing provides a low-cost method of getting the market’s return, and that’s pretty good. Active strategies give the opportunity to either do better, realize a higher rate of income or reduce volatility. The extent to which an active approach should be used depends in large part on an investor's ability and willingness to follow a disciplined, well-thought-out strategy, not on how widely index funds are used by other investors.
The Week Ahead
Taxes are due on Wednesday, April 15. Those of you who haven’t filed yet may find our Tax Guide to be helpful.
First-quarter earnings season will start to gain momentum with 35 members of the S&P 500 currently scheduled to report. Included in this group are Dow components Intel (INTC), JPMorgan Chase (JPM) and Johnson & Johnson (JNJ) on Tuesday; American Express (AXP), Goldman Sachs Group (GS) and UnitedHealth Group (UNH) on Thursday; and General Electric (GE) on Friday.
It will be a busy week for economic data too. The March Producer Price Index (PPI), March retail sales and February business inventories will be released on Tuesday. Wednesday will feature March industrial production and capacity utilization, the April Empire State manufacturing survey, the National Association of Home Builders’ April housing market index and the Federal Reserve’s periodic Beige Book. March housing starts and building permits and the April Philadelphia Federal Reserve’s manufacturing survey will be released on Thursday. Friday will feature the March Consumer Price Index (CPI) and the preliminary University of Michigan April consumer sentiment survey.
Four Federal Reserve officials will make public appearances: Minneapolis president Narayana Kocherlakota on Tuesday, St. Louis president James Bullard and Richmond president Jeffrey Lacker on Wednesday, and Vice Chair Stanley Fischer and Cleveland president Loretta Mester on Thursday.
April stock options will expire on Friday.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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