Here’s an interesting chart showing the cumulative change of money going into index funds and coming out of actively managed funds over the last 15 years.
I’ve commented in the past on indexing. In short, I think it makes sense in some instances but not in others. Most of my concerns revolve around stock index funds in particular. Bonds don’t have any stock related issues like corporate governance, shareholder dilution, etc. Corporate governance is one of the most underrated but important aspects of investing in stocks, and is something I spend a good amount of time on when researching companies. With an index, you get the whole lot – some great companies and some really bad companies. In that sense, I don’t think you can even call it investing. It’s simply speculating that the basket will “go up.” There’s absolutely nothing wrong with speculating and I’m not necessarily advocating actively managed funds over index funds. The point I’m trying to make is that it’s important to understand exactly what you’re doing, what the risks are and question whether a certain vehicle (like an ETF) is the best way to accomplish what you’re hoping to achieve.
ETF’s especially have become great trading vehicles and the increase in daily volume over the past few years confirms this. The plus side if you’re an investor in individual stocks is that all this money going in and out of ETF’s during short-term swings tends to push all the stocks in the basket to wider extremes than they would have gone on their own. This can be an opportunity to buy at lower prices or sell at higher prices.
The index craze in general is starting to feel like past manias though. Today it’s: “you’re a fool if you don’t use index funds because they’re convenient, low cost and they beat actively managed funds (especially value strategies as of late),” like you were a fool in 2004/05 if you weren’t making easy money flipping houses, or you were in a fool in 1999 if you didn’t have your whole portfolio in tech stocks. A general rule of thumb when it comes to markets is that it usually pays to go against consensus.
I’m concerned this is going to lead to problems in the years ahead because stock indexing is a price insensitive strategy. The reflexive nature of index funds (i.e. the self-fulfilling prophecy where more money is allocated to the largest companies since they’re the largest components of the index, driving up those stocks, which helps the index in terms of performance because it’s most heavily influenced by the largest companies, and the performance attracts more money to the index fund, pushing up the price of the largest components even more, etc.) works in both directions. Just like leverage, it creates a larger and longer cycle to the upside, but unfortunately has the reverse effect if/when it starts to unwind, leading to a more drastic move to the downside.
Markets are all about ebbs and flows, and different strategies go in and out of favor over time. I’m confident we’ll look back and see that index funds weren’t the panacea investors are assuming them to be.
-Nick