The index fund is all the rage in financial blogs and throughout academia, and it has been for some time. Research reports and journal articles showing that active investing doesn’t work and that markets are too efficient to allow for mispricing have pulled investors away from stock picking money managers. In addition, index funds make saving for retirement much easier. Why choose 10 or more mutual funds and stocks for your IRA when you could pick three or four? Also, why worry about whether your actively managed funds are five-star ranked by Morningstar or whether your money manager had a bad year?
An Introduction to Index Funds and Efficient Markets
In their simplest form, an index fund simply holds all the stocks that an index, like the S&P 500, holds in the same proportion. The purpose of the fund is to replicate the returns and movement of the index. If the S&P 500 drops by five percent, so will the corresponding index fund. If you don’t believe in active management or the ability to pick the best stocks out of the index for your portfolio, then owning an index fund allows you to have exposure to every stock within the index without having to buy them all yourself. As a bonus, fees on index funds are smaller than actively managed funds.
According to the Efficient Market Hypothesis, the market is efficient, meaning that at any given time, the price shown for a stock is the correct price for that stock. The result is no one should be able to identify any mispriced stocks because none exist. If there is no mispricing, then trying to pick the best undervalued stocks for your portfolio makes no sense. Nothing is undervalued, the stocks are perfectly priced.
The idea behind the Efficient Market Hypothesis is that investors will trade away any pricing imperfections. If a price is too low, the price will immediately change because someone will buy the stock and push the price higher. Today, with the help of computers, millions of investors, and high frequency trading, these mispricing opportunities are small.
The pricing gaps close so fast that, for the normal investor, the market may as well be efficient. In this case, an average investor trying to pick individual stocks for a portfolio is a losing bet. In fact, any positive returns from picking stocks can be attributed to luck, not skill.
What Happens When Everyone Buys Index Funds
The secret is out about index funds. Lower fees, higher returns and less fuss have led to a new trend in personal investing. But, what happens if everyone jumps on the index fund train? Though highly unlikely, it is interesting to go down this thought experiment rabbit hole.
If all investors were 100-percent invested in index funds, then all stocks would move together based on cash inflows and outflows. If Joe invests $1,000, that $1,000 will be split equally amongst assets in the index. This sounds alright until the inevitable situation arises when one stock over or under performs the rest of the index.
For example, assume Disney launches a new park and it is a major success. Everyone from all over the world is buying tickets. This is great news; however, because no one invests in individual stocks, Disney’s stock price doesn’t bounce. It moves like every other stock in the market based on investments in index funds.
In this case, someone will sell their index fund and buy Disney stock directly. It would only take one person. Even if there is no individual left to sell the stock to this Disney buyer, the index fund they left will need to sell their Disney position, along with every other stock within the index to allow for the withdrawal. This will continue to happen, perhaps slowly, until Disney’s stock is back to fair value.
This process will continue to happen repeatedly for all publicly-traded stocks as news is released until these mispricings disappear completely and investors move to index funds all over again. There is nothing new about this philosophy. This is how the market works. Investors flock to new trading strategies until they don’t work anymore. At that point, these investors leave and the trading strategy starts to work again.
Will It Happen?
Index funds are the product of active traders being good at their jobs, which eliminates mispricing. If they become so good they eliminate all mispricing, which may have happened, everyday investors will push capital into index funds. Once index funds have become too good at promoting passive investing, active investing will be necessary to bring prices back to equilibrium, as shown in the Disney example above.
While fun to think about, this situation is highly unlikely. Investment managers will always claim they can beat the market returns by expert stock analysis, whether true or not. In addition, investors will always look for a quick return that will make them rich. It is a match made in heaven and a relationship that will keep the active investing game going for long into the future.