Are too many people investing in index funds?

The idea of index funds was conceived in the 1970s, and received immediate support from some of the smartest academics and economists in the world at the time. Industry practitioners on the other hand, laughed at the idea. Index funds were even called un-American. Who wants to be average?

The first index fund that could be accessed by retail investors was launched by Vanguard in 1975. Despite the long-term existence of index funds, actively managed funds have completely dominated the investment fund market until recently. In the U.S., passive funds have doubled their market share since 2006 – increasing from 17% to 34% of the investment fund universe at the end of 2016. A similar trend has been present in Canada, with the market share of passive funds increasing from 6% in 2007 to 11% at the end of 2016.

People in general are becoming increasingly aware of fees and performance, and there is ever-mounting evidence that favors index investing as the most sensible approach. So what happens if everyone invests in index funds?

The failure of actively managed funds has played a significant role in the growth of index funds. Most active managers underperform their benchmark index. One of the explanations for their underperformance is that markets are efficient, a term that was coined by Nobel Laureate Eugene Fama. It means that security prices reflect all available information. In an efficient market, an active manager does not have an information edge because anything that they can know about a stock is already included in the price. The only way to beat an efficient market is to accurately predict the future, which is very hard to do consistently.

Most people that believe in market efficiency do not believe that markets are perfectly efficient. They believe that markets are efficient enough to make it extremely difficult to know when someone who profits from a trade was skilled, or just lucky.

The way that markets get efficient is by having a lot of people buying and selling stocks based on the information that they have. All of the active managers who are spending resources to research stocks in an effort to make a profit are injecting the information that they have into the price. These aren’t mom and pop operations either. The largest and most sophisticated investors in the world are the ones placing most of these trades.

If markets are efficient, you can’t beat the market consistently, and indexing is the smartest way to invest. But markets can only be efficient if there are enough people trying to beat the market. That’s a paradox, and it has a name. It is called the Grossman-Stiglitz paradox. It was introduced in a 1980 paper titled On the Impossibility of Informationally Efficient Markets.

Let’s think about this practically. If everyone really did switch to index investing, markets would lose some of their ability to accurately set prices. If that happened, there would be inefficiencies in the market and active managers would be able to swoop in and make big profits on mispriced securities. That action of them swooping in and profiting would attract other active managers to do the same.

It’s like an equilibrium. If too many people index, some active managers may profit, but by doing so they will push the market back toward being efficient. Markets are probably not perfectly informationally efficient all of the time, but they are efficient enough that it is very difficult to beat them consistently.

There is no way to know exactly when markets would cease to be efficient in a way that could be exploited consistently, but Eugene Fama, the guy that introduced the idea of market efficiency, explain in a 2005 paper Disagreement, Tastes, and Asset Prices that it depends on who turns to passive investing.

If the misinformed and uninformed active managers turn passive, then market efficiency will actually improve. If the well-informed active managers turn passive, then markets could become less efficient. But even if an active manager with good information turns passive, the effect might be very small if there is still sufficient competition among the remaining active managers. The paper also explains 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.

In a 2014 paper, Pastor, Stambaugh, and Taylor explained that skill and competition have both been increasing in the world of active fund management.

Index investing is growing, but it’s still small in comparison to the long-entrenched world of active management. Even if index funds continue their current growth trajectory, there will always be investors who are motivated enough to absorb the additional risks and costs of active investing in an attempt at achieving higher returns. With the decreasing costs of information and increasing skill and competition among active managers, it is likely that markets will remain mostly efficient for a long time.