If Everyone Bought Index Funds


Index funds can be great, but what would happen if everyone were to invest in them? See Robert Schiller's interview about index funds and what they mean for the health of the market.

What if Everyone Invested In Index Funds?

Recently, Robert Shiller gave an interview on CNBC where he questioned the value of indexing investing and expressed particular concern should 100% of the market move to indexes. What would happen if everyone invested in index funds? Let’s explore that idea.

Robert Shiller is a Nobel-prize winning economist famous for, among other things, developing the Shiller P/E ratio (also known as CAPE) which takes the average earnings of a company over the last decade to smooth out the impact of business cycles and other events to give a better picture of a company’s sustainable earning power. He’s a smart guy that thinks Bitcoin is a bubble. But when it comes to index investing, I’ve got a few questions.

The interview (three-minute video below) raises the following questions:

  • What happens if 100% of investors are invested in index funds?
  • Are passive index investors getting a “free ride” on other people’s work?
  • Why didn’t they talk about index investing 100 years ago?
  • Has passive investing been a bad thing for the market?
  • Was the strength of the country build by people who had opinions on the price of stocks?

Robert Shiller Interview

100% Invested In Index Funds and Free Riding

If 100% of investors owned an index fund, we’d be in a pretty awful situation. Why? Because, we need the active investors to buy and sell stocks to set the price for the various securities. The index funds mostly just track the market capitalization. We can’t know the market capitalization unless an active trader is out there deciding which companies are worth more than others.

But should we fear a coming time when there are no active investors? Not if you’re familiar with the Gotrocks Family. That’s because as long as we have a stock market, we WILL have active traders trying to beat the market.

If the market becomes less efficient as more investors shift to index funds, it only increases the likelihood that some investors will shift to active investing to take advantage of the inefficiency. Plus, do you see people like Warren Buffett and Carl Icahn switching to index funds? They’ll continue doing what they do best and will be happy to pounce if a company’s valuation gets out of whack.

For that reason, I can’t see any scenario where the market becomes 100% index investors. And how many active investors do you really need to set the market prices? Not that many. We only need enough to make sure the market is setting prices efficiently. As long as we have hedge funds, pension funds and Ivy League endowments, we should be fine.

Does that mean as index investors we’re getting a free ride on the work of the active investors? Yes it does. It’s a free ride I’ll happily take. Let the big boys bash each other over the head trying to one up themselves in market. Meanwhile, I’ll capture all the intrinsic growth in the market that comes from the companies actually producing value.

Where Was Indexing 100 Years Ago?

Duh. You couldn’t do index investing before computers. Can you imagine how much work it would be to create a hand ledger tracking 4,331 public companies? And then you’d have to set up a fund that maintained the market capitalization of those companies on a daily basis? Impossible.

So the fact that investors weren’t talking about index fund investing 100 years ago is the same reason they weren’t talking about cat videos. They didn’t exist.

But doesn’t Shiller claim that the strength of the country was built off the backs of those active investors toiling in the market to create efficiency? Sure, the efficiency of the market is critical to its growth. If those traders hadn’t been moving shares back and forth setting prices along the way, we wouldn’t have a functioning market. But let’s not kid ourselves. Those traders were trying to make money, not working for free. And did they create all the value? Well, I’d argue that the vast majority of the value came from the company’s capital and it’s employees working tirelessly to bring profits to the corporation.

Finally, the interview suggest that passive investing might be a bad thing for the market. It’s certainly a bad thing for the financial advisors that think they can select winning stocks for you. It’s a bad thing for the brokerage houses that make money on every trade and thus are heavily incentivized to encourage you to make transaction. But index investing hasn’t been a bad thing for investors. And since it’s your money, would you prefer to help out the market or yourself? I don’t find it convincing that as an investor I should be more incentivized to do what’s best for the market than what’s best for me as investor.

Let’s talk about it. Are you worried that one day index investing will become so dominant that we’ll no longer have active traders? Do you find any of Schiller’s arguments compelling?

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    Ten thoughts on If Everyone Bought Index Funds


    1. If passive index fund investing starts to look less favorable as its popularity leads to increased opportunities for active traders to exploit market inefficiencies, the data will lead people to shift back towards active funds / trading.

      When you frame it that way, the “problem” of index funding seems to be one that will take care of itself. If recent history showed that actively managed funds outperformed index funds 80% to 90% of the time (rather than the vice versa that now exists), I’d be willing to make a change.

      Cheers!
      -PoF

      1. I’m a firm believer in this self-fixing problem theory. Self interest governs investing. The day will come when people see that index funds are being outperformed by actively managed funds. This will primarily be due to the opportunity for active management to exploit inefficiencies that indexes cannot exploit, as PoF says. But it won’t be sold that way: Every active fund will claim that they have “found the secret” or “developed a new algorithm” to predict the winners and losers, and they will point to several quarters of better returns than the indexes to “prove” it, thus justifying increasing fees and causing excitement in an easily-duped public. Enough people will jump off the index fund bandwagon to return the market to a place of balance in the Force – or rather, where the Force will again favor index investing.

    2. I’m with you, let the folks on wall street duke it out. If prices go out of whack there will be plenty of traders looking to capitalize. Trading is work, and right now I don’t see enough of an incentive to jump into the competition. I’ll keep my index funds and concentrate on my home brewing and gardening 🙂

      1. So there’s more to life than building up the biggest stash of cash?! Hold the phone! BTW, I’m thinking about trying my hand again at balcony gardening after being inspired by our meetup in Central Park (and your offer to ship chicken poop to me). Let’s just say the jury is still out on my need for fertilizer but I’m interested in any advice on what might grow best on a balcony.

    3. The fact that everyone is investing in index funds does bother me somewhat. Right now it seems to be the best way to go. BTW Buffet wants his wife to invest in indexes after he is gone.

    4. From a statistic I read the market is about 30% in index funds. Index funds like VTI do not own all of the index. They own a statistical sub portion of the index (tracking stocks) which tracks the index. So what happens in a crash when everyone is diving for the exit? Does index investing actually represent an increased SORR risk because stocks that may not be particularly be affected by a down turn but are tracking stocks get swept into the drain as index companies trying to match redemption? In other words are index funds really volatility time bombs? If a stock might go down 10% naturally but is swept down 30% because of index fund liquidation and it just happens to be one of the funds tracking stocks, how does that affect your volatility? I think that’s the true danger of index investing.

      There are a million ways to make money in the market beside index investing. I used to day trade for example. Market makers are there to make markets so I don’t understand what Shiller is talking about. It’s just CNBC nonsense.

    5. I like your article and thoughts, but I think all the comments about “active trader” miss the point.

      The big issue with more and more passive investors is the lack of corporate governance. Vanguard, Blackrock, and State Street rarely take stances and the power lies in a proxy advisory firm. A company’s management can help nominate an insulated board with little ownership and promote self enrichment. If an activist investor shows up, they have to fight with their own money while management fights back with shareholders money.

      There are some some victories, but it’s usually a quagmire and the shareholders loose. Occasionally an activist will win (Darden), but it has to be so agregious and in a “free” industry like Food and Beverage.

      Look at the banking sector right now, Comerica has underperformed for years and has an outspoken analyst who’s pushed for change for years. Instead of anything happening, a 70+ year old CEO blowing all the shareholders money on sports sponsorships while providing a 6% return on equity.

      I’ll probably end up writing a post on this before it’s done, but that’s the risk of passive investing, lazy management of large companies rewarding themselves at the expense of the shareholder

    6. Index funds existed over 100 years ago. Dow Jones Transportation Average (1884); Dow Jones Industrial Average (1885).

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