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3 Reasons Index Investors Deserve Perdition (or Not)

Do the arguments that indexers are hurting the market hold water? 

John Rekenthaler, 08/11/2017

The Hot Seat
Lex III: Actioni contrariam semper et aequalem esse reactionem: sive corporum duorum actiones in se mutuo semper esse aequales et in partes contrarias dirigi.

More colloquially, for every action there is always opposed an equal reaction—Newton’s Third Law of Motion. To his misfortune, Newton knew nothing of index funds—they would have served him far better than the South Sea shares that he so disastrously purchased—but his axiom applies to their discussion.

Because what went up is very much coming down. To be sure, most financial journalists continue to recommend index funds. However, several other groups are resisting, loudly. Active portfolio managers, brokerage firms, and financial advisors, who have long criticized the practice of indexing, have intensified their complaints. They, of course, have axes to grind. But recently they have been joined by some academic researchers, against which the charge of self-interest is more difficult to make.

In order of seriousness, the criticisms sort into three categories:

1) Index funds have inflated the stock market.

2) Index funds have distorted how equities are priced, by bloating the shares of companies that are in the popular indexes, and neglecting the shares that are not.

(These two arguments might seem similar, but they are not. The first states that the Dow Jones Index has become overvalued, while the second says nothing about overall index levels, but instead questions the market’s internal efficiency.)

3) Index funds harm the process of corporate governance.

is vice president of research for Morningstar.

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