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Do Index Investors Deserve Perdition?

“Not guilty” on all counts.

John Rekenthaler, 10/11/2017

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 whom the charge of self-interest is more difficult to make.

In order of seriousness, there are three charges:

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 market indexes have 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.

Toil and Trouble
The notion that index funds have created a stock-market bubble can easily be popped. (Sorry about that.) For one, this claim is customarily made by citing the inflows into indexed mutual funds and ETFs. The conclusion is grossly premature. To understand how much of total stock-market inflows comes from indexing, one would need to add the figures from the other major participants: pension funds, foreign investors, individual buyers, and the corporations themselves.

is vice president of research for Morningstar.

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