A Self-Fulfilling Prophecy

In 2016, a record $504 Billion Dollars was invested in index tracking passive funds. This follows up flows of $418 Billion and $422 Billion the previous two years into these types of investments according to a 2016 Morningstar report. Considering the total fund space contains about $15 Trillion dollars, those movements of about 9% per year are large.

Call us what you will, but these movements make us a little uneasy. In a piece, we did a few months ago called “In the Index” we explained how some major indexes are selected and made mention of new indexes created so that ETFs can track them. In a recent graph from Bloomberg we now see that the number of indexes has surpassed the number of stocks in the market. This seems strange considering what an index was originally meant to do, which is track a market.

This dramatic increase started around 2010 when many new indexes were created to repackage a management style into an algorithm that can control a fund.  It is yet to be seen how the thousands of new indexes created every year will hold up in different market conditions. Many of these indexes are created for ease of marketing and focus on factors like price momentum or low volatility. Are those the most important factors to look at for a company? Who knows, but now there’s a way for people to directly pour hundreds of millions of dollars into the stocks at the top of those lists. Anyone else see bubble potential there?

Another reason we don’t like this behavior is because the more popular indexing gets, the more money that goes into the mother of all indexes, the S&P 500. This focuses returns on the largest companies because of the S&P’s market-cap weighting. Steve Sjuggerud reported in his DailyWealth newsletter that the 10 largest stocks in the U.S. (which make up about 20% of the S&P) have returned an average of 30% over the past year while the S&P 500 was up around 15% as a whole. So, did those companies outperform because they’re great companies? Or was it because 20% of $504 Billion was invested in them through index fund flows?

You now see the conundrum here. Big companies are at the top of the index because they’re big. This means they get more money invested in them because they have heavier weightings. This drives up share price and market cap, making them bigger. Which gives them an even heavier weighting for the next money that comes and… I think you get the point.

The effect that we and some other smart people like DoubleLine Capital, Bond Fund manager Jeff Gundlach and J.P. Morgan Global Market Strategist Nikolaos Panigirtzoglou suspect is that these top-heavy indexes could give markets less of a leg to stand on if the market falls on hard times. They also think people being able to jump in and out of factor and sector index funds could create more volatility and could potentially make the market less efficient.

The good news is, less efficient markets are usually a very good think for active managers because the good companies they want to own will go on sale more often.

Just like the S&P goes through bull and bear cycles, so too do styles of investing go in and out of favor. This hysterical flocking to index investments has been a good gig recently, but I wouldn’t be the one to bet that ignoring company fundamentals and blindly investing in indexes is going to be the winning ticket from now on.

As Andy Keller wrote, “Markets don’t create wealth. They allow for price discovery…”. We shall see what they discover when index investors get spooked and have access to a mass eject button.