The Index Fund Bubble - YouTube

- A lot of people are worried

about how index funds might affect the integrity

of the stock market.

At the extreme, people have even compared index funds

to the collateralized debt obligations

that sent the global financial market into crisis in 2008.

One of the foundations of a so-called index fund bubble,

is the idea that index funds affect price discovery.

They affect the market's ability to efficiently

incorporate information into prices.

If a stock's price is being bid up

for the sole reason that it is included in a popular index,

as opposed to the careful analysis of an active manager,

then there could be serious room for error in prices.

I'm Ben Felix, portfolio manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you why index funds

are not creating a bubble.

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With billions of dollars flowing

into market cap weighted index funds,

it seems like a valid concern that larger stocks

which make up a larger portion of the index

are being irrationally bid up in price.

While smaller stocks are being forgotten.

If this is happening, large popular stocks

like those in the SMP 500,

could become systemically overpriced

and smaller lesser known stocks

could become systemically under priced.

Adding to this perceived price distortion in the market,

is the fact that US small cap value stocks

have underperformed the US large cap growth stocks

for over a decade.

Over the longterm, small value stocks have

and are expected to outperform large growth stocks.

To be clear, this is not the first time

that small cap value stocks

have trailed large cap growth stocks for over a decade.

Things looked very similar in the late nineties,

right up until the tech crash.

When small cap value reclaimed it's throne.

To understand how index funds might affect stock prices,

We need to understand how prices are set.

Prices are set by trading.

Each trade is a vote for the price going up or down.

The aggregation of all of these votes is the current price

which is the market's best guess

at the actual value of a company.

If index funds are the only entities placing trades,

buying up more of the biggest stocks

to match the market cap weighted index

so that there's tracking,

then there could be some serious issues.

Index funds have grown dramatically

in terms of assets under management.

This is what is causing alarm bells to go off.

In the United States,

index funds make up roughly half of fund assets.

That is a large portion of the overall fund market,

enough to make people start to worry.

But it is also an extremely misleading figure.

In the late Vanguard founder, John Bogle's final book.

He explained that in 2018, when the book was written,

index funds own roughly 15%

of the US stock market compared to only 3.3% in 2002.

I will take this opportunity to point out

that the last time small cap and value stocks

were trailing large cap growth stocks, as they are now,

index funds were a much smaller portion of the market.

If we look past the US, a 2017 study

from BlackRock estimated

that index strategies as a whole,

made up 17.5% of the total global market.

But this includes institutional

and internal indexing strategies executed directly

by large institutions,

as opposed to through index ETFs or index mutual funds.

They found that only 7.4%

of a global market was owned by index funds.

The point of me telling you this,

is that headlines about half

of the market being indexed are overblown.

Index ownership of the market has increased

but it is still relatively small.

I thought that clearing that up was important,

but it isn't actually relevant to this discussion.

Assets under management do not set prices.

Trading sets prices.

The relevant question is not how much

of the market is indexed,

but how much of the trading index funds are doing.

If index funds are not doing the majority of trading,

then it is still the active managers

dominating price discovery.

The majority of ETF trading is happening

on the secondary market.

That is ETF unit holders trading with each other.

It is only when there are deviations

between the price of the ETF

and the value of the underlying securities,

which you can think about as excess supply or demand

for the ETF units, that the authorized participant

will create or redeem ETF units.

Unlike secondary market transactions,

the process of creating and redeeming ETF units

requires trading in the underlying stocks.

In a 2018 paper titled,

"Setting the record straight: Truths about indexing",

Vanguard demonstrated that the vast majority

of equity ETF trading, 94% on average,

is done on the secondary market.

Meaning that ETF unit holders are buying

and selling from each other

without touching the underlying securities.

In their 2017 paper,

"Index Investing Supports Vibrant Capital Markets",

BlackRock presented a similar figure.

Showing that ETF creation makes up a tiny fraction

of US equity dollar trading volume.

This point is important in understanding

why index funds make up such a small portion

of overall trading.

But it is also important in understanding

why concerns about the liquidity

of the underlying holdings are over-blowing.

Most of the trading does not touch

the underlying securities at all.

The Vanguard paper that I mentioned,

reports that of all trading activity in the stock market,

index strategies are only responsible for about 5% of it.

Think about that, only 5% of total trading

is executed by index funds

While active mandates are executing the rest.

BlackRock similarly estimates that for every $1

of stock trades placed by index funds,

there are $22 of trades placed by active managers.

This destroys the price discovery argument.

Price discovery, which is driven by trading,

is still dominated by active managers.

We also have to think about market dynamics.

Even if it happened that index funds

did get to the scale of trading

where they could create price distortions,

each distortion is an opportunity for an active manager.

If there are more distortions,

more active managers will come to the table to profit

in their 1980 paper on the impossibility

of informationally efficient markets,

Sanford Grossman and Joseph Stiglitz explained

that the market must exist in an equilibrium state.

If the market were perfectly efficient,

everyone would index, which would lead to price distortions.

Therefore, as soon as we reach

what we might call "peak index",

where the market stops pricing assets correctly,

the active manageable profit by getting prices back in line,

driving more people to invest actively.

This equilibrium state is known

as "the Grossman Stiglitz paradox"

Markets can't be perfectly efficient

because by nature of perfect efficiency,

they would become any efficient.

In a way concerns about indexing,

causing some sort of bubble

are really just suggestions that we have reached peak index.

We've reached a point where active managers are not

able to exploit price distortions caused by index investors.

This seems unlikely based on the magnitude

of trading that is still being done by active managers.

And it seems even more unlikely due

to how the market should respond to manager's skill.

As indexing grows and assets under management, it must mean

that assets are leaving actively managed mandates.

If there are skilled active managers out there,

we would not expect them

to be the ones losing their assets to index funds.

In their 2005 paper,

"Disagreement Tastes and Asset Prices",

Eugene Fama and Ken French examine how this might play out.

If the assets managed by misinformed and uninformed

active managers moves into index funds,

then the market will become more or efficient.

Even if assets managed by skilled managers turn passive,

the effect on market efficiency might be small

if there is sufficient competition

amongst the remaining active managers.

Fama and French also explained

that costs are an important factor.

If the costs to uncovering

and evaluating relevant information are low,

then it doesn't take much active investing

to get markets to be efficient.

From this perspective, the pressure

of indexing may be pushing bad active managers out,

leaving only the skilled managers

which should make the market more efficient

on a similar line of thinking,

a 2019 paper titled,

"Passive Asset Management,

"Securities Lending, and Asset Prices"

by Darius Palia and Stanislav Sokolinski

suggested that the growth of index assets

has reduced the cost of shorting.

Index funds passively hold large amounts of securities,

which allows them to lend

these securities out to short sellers.

This is a key revenue source for index funds

and it is one of the reasons that their fees are so low.

Based on this, as the paper suggests,

the competence for securities lending revenue

has decreased the cost of short selling

which should facilitate more efficient price discovery.

Contrary to the hype, there is a pretty good argument

that the growth in index funds

is driving out the bad active managers

and decreasing the cost of short-selling,

both of which should make the market more efficient.

Let's take the other side of this argument for a minute.

Let's assume that index funds really are driving

up the price of larger stocks

while small cap value stocks are being forgotten altogether.

How should you approach the situation?

The simple answer is underweighting large cap growth stocks

and overweighting small cap value stocks in your portfolio.

And Hey, guess what?

This is something that you should probably think

about doing anyway.

If the market is not broken, if it is still

pricing assets appropriately based on their risk,

then small cap value stocks have higher expected returns

in large cap growth stocks.

If the market is broken due to index funds,

then small cap value stocks are currently

under priced and large cap growth stocks are overpriced.

In either case, a portfolio tilt away

from large cap growth stocks

and towards small cap value stocks, is sensible.

I hope that this video cleared up the misconceptions

that have been floating around about indexing.

Indexing is not a bad thing.

It is only responsible for a tiny fraction

of trading and trading is what sets prices.

There are even some good arguments to be made

that the growth in indexing is making markets more efficient

by driving out unskilled active managers

and reducing the cost of short selling.

Finally, whether the concerns about price distortions caused

by index funds are valid or not,

a tilt towards small cap value stocks

is a sensible approach to portfolio construction.

Thanks for watching.

My name is Ben Felix of PWL Capital

and this is Common Sense Investing.

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