Does Indexing Harm Financial Markets?

This is part of an article from The Economist dated January 17th of this year; subtitled: “Critics of passive investing at last have a case that it distorts markets.”

“In 2016 researchers at Bernstein, a broker, published a note entitled, “The silent road to serfdom: why passive investing is worse than Marxism.” A decade later the revolution is still in full swing. Trillions of dollars of capital have poured from actively managed investment funds into those that simply track market indices, and the flow shows no sign of stopping. As much as 60% of net assets overseen by American equity funds are in such passive vehicles, estimates the Investment Company Institute, an industry group.

Today, a note like Bernstein’s, which at the time provoked plenty of headlines and approving references on trading floors, would merely provoke eye-rolling. No one is surprised that analysts who sell research to stock pickers dislike passive funds that are outcompeting their clients. Over the years claims that such funds are bad for markets have tended, similarly, to come from people whose salaries might be higher if they [e.g. index funds] were to disappear. Meanwhile, the once revolutionary creed that motivated the creation of tracker funds has come to feel like common sense. What investor doesn’t know that mostactive managers fail to beat their benchmark index, while the passive alternatives hug theirs closely and charge rock-bottom fees.

None of this, however, means that passive investment really is harmless. Its detractors make a valid complaint: markets’ social function is to direct capital to where it will be used most effectively and passive funds make no attempt to do this. Their indiscriminate buying could therefore pull share prices out of whack with underlying earnings. Pulling in the opposite direction are arbitrageurs, such as hedge funds, which can take the opposite side of tracker funds’ trades and profit from bringing prices into line with fundamentals. Yet a much-discussed working paper—at least among active fund managers— makes a compelling case that the arbitrageurs have a far weaker effect than is commonly thought. If so, then flows of assets into passive funds really could be distorting share prices and helping inflate a bubble.

The paper, by Xavier Gabaix of Harvard University and Ralph Koijen of the University of Chicago, sets out their ‘inelastic markets hypothesis.’ This contradicts the textbook argument that money flowing into stocks should barely raise prices, since if it did, demand would fall and return prices close to their starting level. In fact, the paper’s authors find that stockmarket demand is not ‘elastic’ in this way. It is inelastic and does not fall much as share prices rise. As a result, an investor who buys $1 worth of stocks using fresh cash (or the proceeds of selling other assets such as bonds) pushes up aggregate market value by $3.8 [e.g. $3.80].

…In 2024, estimates Vanguard, a passive-investment giant, 64% of Americans’ pension-pot contributions went into ‘target-date’ funds. These portfolios split their investments between stocks and bonds in proportions determined by when savers hope to retire rather than by market prices. If Messrs Gabaix and Koijen are right, each dollar of this steady flow drives up stockmarket value by several more, regardless about what investors think about firms’ future profits. It’s not quite Marxism—but not altogether reassuring either.”

Smartt comment: I have several points to make in contrast: (1) Not all but much of our ETF buying activity is buying from a willing seller; no increase in the number of ETF shares outstanding generally results from such stock buying activity. The ETF itself does not make any new stock purchases, and some of the existing shares of the ETF have just been purchased from another individual seller. (2) The preponderance of my clients are buying a mix of bonds and stock, not just stock. (3) When stock values are relatively high, our stock buyers are usually purchasing a set amount of stock per month (e.g. $10,000 added once per month), “trolling” money gradually into stocks; so when stock prices are higher, we are purchasing fewer shares. And finally, (4) in the year 2025 my client base began the year owning 101,581 shares of VTI, Vanguard’s giant Total Stock Market Index ETF. At the end of the year, we owned 88,776 shares. E.g. our number of shares decreased by 13%, we were sellers, not net buyers in a year in which the share price of VTI increased by 16.0%. We weren’t actively fighting any market trends, but when we needed money and when stock values were relatively higher, we tended to sell stock not bonds. I acknowledge that if indexing takes over completely, the market collapses, but I do not believe that this is ever going to happen. The hedge fund managers are too well paid to cease their efforts. And there are too many individuals who like to be stock pickers.

If you have questions about this, please contact me.