What Happens If Everyone Indexes? (Part 1)

Alex Bryan: Happy to be here.

Benz: It's good to have you in person, too, for a change. Let's talk about some of the things that we've seen swirling around ETFs and index funds. As they've grown, some market watchers have voiced concerns that there could be these unintended consequences. So, a biggie that we often hear is that somehow the flow of assets into indexes will cause the markets to be less efficient. It'll cause these, sort of like, market dislocations. Let's talk about just the thesis of why things might work that way. 

Bryan: Sure. So, one of the concerns is that as more and more people invest in index funds, and more and more active managers kind of drop out of the market, there's fewer people that are dedicated to doing fundamental analysis on individual securities, and more and more people kind of buying and selling the entire market. In that case, if everybody pulls money out of the market, they may throw out the good stocks, the bad, and that could potentially cause more mispricing in the market than if you have more fundamental stock-pickers doing research and figuring out what each of these stocks are worth. So, that's the concern.

Benz: And the mispricing would be a problem if I'm an index fund investor, because I could end up in some massively overvalued stocks, or ...?

Bryan: That's a concern. Yeah. So, if the market is not efficiently priced, then you could end up owning big stakes and stocks that are overvalued. This was a concern back in the late 1990s when tech stocks were close to 40% of the S&P 500 and those stocks were pretty overvalued. And so, there's that risk that if the markets aren't efficiently priced, you could end up owning a lot of things that are quite a bit expensive.

Benz: So, is this something I should be worried about? And let's start with the perspective of if I'm a passive fund investor, but also, how about for active fund investors?

Bryan: So, I think it's a concern that I think gets overblown. It's kind of this theoretical discussion that comes up in academic circles. What if everybody were to index? What happens then? I think it really depends on who's dropping out of the market. That's number one. So, if the people who are dropping out of the active market are managers who are less skilled, and I think that's more likely the case ...

Benz: Probably something we're seeing right now, right?

Bryan: Exactly. If investors are kind of fed up with years and years of underperformance, and those poor managers drop out, the market could arguably become more efficient, because the managers who are left who are doing the research are arguably more skilled. So, that's one thing I would mention.

Bryan: The second thing is, although index funds have a pretty large share of total assets that are invested in managed funds, about 40% in the U.S., their share of trade volume is much lower. And that's because turnover in index funds tends to be a lot lower than the turnover ...

Benz: They're not trading.

Bryan: Exactly, they're not trading quite as much. Price discovery happens on the margin when shares trade hands. So, if index funds are accounting for a much smaller share of the overall trade volume than they are of total asset ownership, then actually active managers are still driving most of the price discovery that's happening. So, I think we're a long way from this being a problem. It's not to say that it couldn't be a problem at some point, but we're not there yet. And if we ever were to get to that point where there did, you know, become more mispricings, well, then active managers should start doing better and I think there will be this equilibrium that the market finds where people might shift back to active and back and forth until we find that equilibrium.

Benz: That's what active managers are definitely helping, I know. Let's talk about another concern. You think this one is a little more legitimate. And this is in the case of indexes where maybe those securities are a little less heavily trafficked, where there is a reconstitution of an index fund that's tracking that space, that there can be higher transaction costs. Let's walk people through how this works, when index fund makes changes how that causes funds to have to play catchup.

Bryan: So, whenever an index fund reconstitutes, so when there's a – let's say, stocks that are removed from an index, well, everybody who tracks that index, like the S&P 500, has to sell those securities at about the same time regardless of the price that they get. Now, what that tends to cause is, it causes the prices of those stocks to drop when they're removed. Similarly, stocks that are added to the index see a price pop when they're added, but oftentimes, the index investors are getting the less favorable prices because they're not able to buy those newly added securities until after the price goes up or sell until after the prices have gone down. So, this can cause the performance of the index to be a bit less attractive than it otherwise would be if it weren't forced to buy and sell on these predefined dates. And that's one of the reasons why a firm like Dimensional Fund Advisors doesn't like to track an index. It follows a broad market ...

Benz: To take advantage of these sorts of issues.

Bryan: Exactly, exactly. So, that's the concern. And it's, as you mentioned, more acute problem with less-liquid assets, like small-cap stocks, like high-yield bonds, that's where these costs tend to be more pronounced.

In part two of this article, we will continue with this conversation between Christine and Alex.