The Growing Popularity of Index Funds
Thursday, April 9, 2015

Is there too much money going into index funds?

This is a common question I have heard raised at conferences and other industry events. It’s being raised because of the growth of Vanguard and, secondarily, the growth of exchange-traded funds (the overwhelming majority of which are index funds.)

A common line of thought is that as more money flows to funds following market-cap-weighted indexes, the indexes themselves will have more influence over the valuation of companies. Since most widely followed indexes assign greater weights to some companies than others, the most popular companies see their valuations rise as dollars flow into index funds. A second (and related) argument is the potential for more inefficient pricing of stocks, particularly those with smaller or no weighting in the most widely followed indexes. This mispricing would create opportunities for active stock pickers, while those investors tied to the indexes would miss out on the opportunity for higher returns. There are other arguments against the growth of indexing—including how the indexes are constructed—but the majority fall into the “influence” or “greater inefficiency” camps.

The growth of indexing cannot be underestimated. Four of the five largest funds listed in our 2015 Mutual Fund Guide are Vanguard funds: Total Stock Index (VTSMX), S&P 500 Index (VFINX), Total Bond Index (VBMFX) and Total International Stock Index (VGTSX). Combined, these four funds alone control more than $850 billion in assets. To put this number in context, these four funds manage more assets in dollar terms than the next 10 largest mutual funds combined do.

A skewing toward the most widely followed indexes also exists in the exchange-traded fund (ETF) industry. The SPDR S&P 500’s (SPY) assets under management of $181 billion are more than double those of the second-largest ETF, the iShares Core S&P 500 (IVV). Notice that the largest and second-largest ETFs both follow the same market-cap-weighted index.

As large as these numbers seem, indexing still accounts for a small share of the overall investment bucket. In his latest Intelligent Investor column, Jason Zweig cited data from Empirical Research Partner estimating indexing’s share of the total value of the U.S. stock market at just 11.5%. The number should not be surprising when the bigger picture is considered. While Vanguard is a mutual fund giant, institutional investors (e.g., pension funds, endowments, insurance companies, etc.) have huge portfolios and use tailored strategies based on their specific short-term needs and long-term goals.

Where indexing has made big inroads is among individual investors. While this is not a favorable trend for companies relying on higher fees from active management, it is a good trend for individual investors. A dollar not spent on fund fees is an extra dollar of wealth maintained for future growth. The downside of indexing is not its influence over the market, but rather the returns of the market. A properly designed index fund will never beat the index it is designed to follow. To do better than the index, an investor has to follow an active strategy. (Tactical approaches for determining when to get in or out of in index fund are still active approaches; they simply use passive investments as the vehicles for carrying out the strategies.)

Active approaches are not without downsides either. The majority of active strategies fail to beat their index benchmarks over the longer term. Even if indexing were to further grow considerably in size, the active strategy obstacles of costs, proper implementation, size (meaning too much money trying to follow the same strategy) and discipline would continue to exist.

There will always be a role for both index (“passive”) and active strategies. Indexing provides a low-cost method of getting the market’s return, and that’s pretty good. Active strategies give the opportunity to either do better, realize a higher rate of income or reduce volatility. The extent to which an active approach should be used depends in large part on an investor's ability and willingness to follow a disciplined, well-thought-out strategy, not on how widely index funds are used by other investors.

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The Week Ahead

Taxes are due on Wednesday, April 15. Those of you who haven’t filed yet may find our Tax Guide to be helpful.

First-quarter earnings season will start to gain momentum with 35 members of the S&P 500 currently scheduled to report. Included in this group are Dow components Intel (INTC), JPMorgan Chase (JPM) and Johnson & Johnson (JNJ) on Tuesday; American Express (AXP), Goldman Sachs Group (GS) and UnitedHealth Group (UNH) on Thursday; and General Electric (GE) on Friday.

It will be a busy week for economic data too. The March Producer Price Index (PPI), March retail sales and February business inventories will be released on Tuesday. Wednesday will feature March industrial production and capacity utilization, the April Empire State manufacturing survey, the National Association of Home Builders’ April housing market index and the Federal Reserve’s periodic Beige Book. March housing starts and building permits and the April Philadelphia Federal Reserve’s manufacturing survey will be released on Thursday. Friday will feature the March Consumer Price Index (CPI) and the preliminary University of Michigan April consumer sentiment survey.

Four Federal Reserve officials will make public appearances: Minneapolis president Narayana Kocherlakota on Tuesday, St. Louis president James Bullard and Richmond president Jeffrey Lacker on Wednesday, and Vice Chair Stanley Fischer and Cleveland president Loretta Mester on Thursday.

April stock options will expire on Friday.

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AAII Sentiment Survey

Neutral sentiment spiked to a 12-year high in the latest AAII Sentiment Survey. The percentages of individual investors describing themselves either bullish or bearish fell.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 6.7 percentage points to 28.7%. This is a three-week low. The drop puts optimism below its historical average of 39.0% for the fifth consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, surged by 14.5 percentage points to 47.2%. Neutral sentiment was last higher on February 6, 2003 (51.4%). This week’s jump puts neutral sentiment above its historical average of 30.5% for the 14th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, pulled back by 7.8 percentage points to 24.1%. The historical average is 30.5%.

Not only is neutral sentiment at an unusually high level, it is at an unusually high level for the third time in five weeks. Historically, unusually high levels of neutral sentiment have been correlated with better-than-average market performance over the following six- and 12-month periods. (See “Analyzing the AAII Sentiment Survey Without Hindsight” in the June 2014 AAII Journal for more information.) There is no guarantee history will repeat in the future, however.

During the past five weeks, there have been notable swings in all three sentiment indicators. Bullish sentiment has fluctuated within a 10-percentage-point range, neutral sentiment has moved within a 14.5-percentage-point range and bearish sentiment has swung within nearly an eight-percentage-point range. The up and down movements have occurred as stock prices have been more volatile, the odds of an interest rate hike occurring sooner rather than later have increased and projections for first-quarter earnings have been reduced.

Keeping some AAII members encouraged is the ongoing bull market, sustained economic expansion, earnings growth and still-accommodative monetary policy. Causing other AAII members to be cautious or pessimistic are prevailing valuations, disappointing earnings or guidance from certain companies, geopolitical events, the pace of economic growth and worries that an even larger decline in stock prices could occur.

This week’s special question asked AAII members how they think the average consumer is faring relative to one year ago. Responses were mixed. Slightly less than a quarter of all respondents (24%) said the average consumer is doing better, primarily because of lower gasoline prices and an improved labor market. About 19% described the average consumer as faring somewhat/slightly better thanks to lower gasoline prices and improved labor market conditions. Roughly 21% said the average consumer is faring about the same, with the lack of wage growth as the most common reason. Nearly 18% of respondents said the average consumer is faring worse due to higher prices (excluding gasoline) and a lack of wage growth.

Here is a sampling of the responses:

  • “I think consumers are doing better due to more people being employed and the lower cost of gasoline.”
  • “Slightly better because of the improved job market and the reduction in gas prices.”
  • “Less well. Food prices, insurance costs, everything but gasoline is up; wages are flat or are up much less than costs are.”
  • “Not much better with stagnant wages and continued underemployment.”


This week’s Sentiment Survey results:

Bullish: 28.7%, down 6.7 points
Neutral: 47.2%, up 14.5 points
Bearish: 24.1%, down 7.8 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!