When everyone realizes index funds are the way to invest, the market will suffer

Look out.
Look out.
Image: Reuters/Brendan McDermid
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No one loves index funds more than I do. I once worked for a company where I participated (with enthusiasm) in veritable jamborees celebrating their virtues and decrying the lunacy of active management. But even I am starting to worry we may be reaching peak low-fee.

What the chart above shows is that more investors are catching onto the fact that index funds are awesome. Instead of handpicking (or machine-picking) a collection of stocks that are expected to outperform the market, indexed portfolios contain stocks weighted by their market capitalization.

Active stock-picking is expensive because it requires research and skill. But that skill may not be so useful; there’s evidence that active funds, after fees, don’t deliver a higher return than a simple index fund. And fees are important. Suppose you invest $100,000 for 20 years: Paying just 1% in fees will cost you $42,000 in expected returns.

It’s no wonder more investors are going passive, a trend driven by both retail and institutional investors. More 401(k) plans are offering passive funds. And some large pension funds are saying no to high fees, and indexing instead. (The latest trend in passive investment is weighting index funds based on factors rather than market share—placing a higher weight on smaller companies or value plays, for example. This can boost returns compared to more agnostic indexing, though some factors introduce more risk.)

But the move to more indexing also creates a number of concerns that there may be too much of a good thing.

Taken to the extreme, if everyone invested in index funds, investment dollars wouldn’t be rationed based on value and prospects for future profitability. Companies wouldn’t get the discipline of informed investors deciding whether they are good investments based on fundamentals. And large companies would get all the investment, putting smaller companies at a disadvantage and making industry disruption all the more difficult.

But odds are we’ll never live in an all-index world. If we did, stocks would become mis-priced, in which case it would be possible to beat the market, and active management would be come back into fashion.