Structurally, the markets function because there are multiple independent actors buying and selling assets and setting prices. This price discoverability is an essential element of a well-functioning market.
Imagine now that investors stop dealing in individual assets altogether, and instead buy a basket of goods, with no thought or regard to what is included in this basket. The companies that assemble the basket will go out and buy the components of the basket as the demand for the basket goes up. But they do not particularly care what these independent components cost, or whether they are worth the price they are paying (value). In fact, very few people in this market care about the individual components of this basket.
The investors in this market, where most transactions are the baskets, not the individual stocks, are neither aware of, nor care for, if the stocks that make up these baskets are:
- A good value,
- represent a solid company with a great business, and,
- has companies with management that are committed to growing shareholder value.
An investor that has been told to just buy the S&P 500 index fund (or ETF) doesn't really care about the companies that make up the stock index. He just wants to buy or sell the entire index.
If index funds and ETFs are a small part of the market, there are still enough independent investors out there that help with setting the correct price of the equity assets in the market.
But what happens if the index funds make up most of the market?
From the stats I have seen, about 50% of the investment capital in the market today is invested in the index funds and ETFs. Of the remaining, most are invested in other funds that tend to be a pseudo index fund anyway. We now have a situation where:
- Investors are passive and do not want to worry about "owning" of businesses.
- Fund managers invest in an index and do not worry about exercising their shareholder and management oversight roles. They vote with the management for most of the shareholder proposals. It is not their job to exercise their shareholder rights.
- Managers of the businesses no longer face the shareholder scrutiny that they traditionally used to.
Granted there are activist investors who try to take advantage of the deteriorating market structure and in the process, bring some more efficiency in the market. But all told, the vast majority of the investment dollars in the market come from retail investors, pensions and endowments, and the prevailing wisdom of the crowds is to just invest in an index and be done with it.
This is the situation we find ourselves in today. Major indexes like the S&P 500 are overvalued but they continue to increase as more index fund investors pile on. The stocks that make up some of these indexes are overvalued and getting more so every day. What we have today is a bubble in the indexes and at some point, this bubble will deflate.
Index funds do have a role to play but like most other things to do with economics and human behavior, they are subject to the cycles of euphoria and despondency. This is a new kind of situation in the market that very few people worry about. However, one of those who have given this a lot of thought is John Bogle, the founder of Vanguard Funds and arguably the key person who ushered in the trend towards indexing.