- 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. (upbeat music) 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. If you enjoyed this video, please share it with someone who you think it could benefit from the information.
Don't forget if you've run out of Common Sense Investing videos to watch, you can tune in to weekly episodes of the Rational Reminder podcast, wherever you get your podcasts.
