The market share of index funds has been growing rapidly, with passively managed funds surpassing actively managed mutual fund assets. Morningstar recently reported that index funds could potentially make up 70% of total mutual fund assets within the decade. This growth raises questions about the potential risks to retirement savings and the capital markets if this trend continues. However, savvy investors may also find opportunities as index funds become more prevalent in the market.
The popularity of index funds can be attributed to their low-cost structure and consistent outperformance compared to actively managed funds. The rise of robo-advisors and increased awareness of the benefits of diversification through index funds have also contributed to their popularity. As a result, the six largest mutual funds in the world are all index funds, showcasing their dominance in the market.
Theoreticians and software programmers use a process called “the boundary condition test” to test the sustainability of any theory or simulation in extreme scenarios. In the case of index funds, it is important to consider what would happen if they were to capture 100% of the investing market. While this scenario is highly unlikely, it raises concerns about the potential impact on capital markets and the need for gains, essentially arbitrage opportunities, in the market.
Should index funds dominate the market, there could be implications for publicly traded companies, Initial Public Offerings (IPOs), and private markets. Index fund dominance could impact the pricing mechanism of publicly traded stocks, potentially leading to a freeze in the capital markets. Similarly, IPOs rely on active investors for price discovery, which could be compromised in a market dominated by index funds. Private markets could also be affected by the lack of pricing information for individual assets.
Despite the growth of index funds, there is no evidence of negative impacts on the capital markets. While concerns about market freezing and lack of price discovery persist, the existence of ‘leaks’ and arbitrage opportunities suggest that a pure index fund environment is unlikely. Investors may continue to seek gains through active management, leading to a balance between index and non-index funds in the market.
Retirement savers are likely to benefit from the trend towards index funds, as they offer lower management costs and greater stability of value. While concerns about the long-term implications of index fund growth exist, experts believe that there is no obvious risk for retirement savers. As more investors choose index funds, profitable arbitrage opportunities may arise for those who research individual companies and trade on pricing discrepancies.
Ultimately, the growth of index funds presents an opportunity for investors to explore new avenues for investment gains. While concerns about index fund dominance persist, a balanced portfolio between index and non-index funds is generally recommended. The advice to moderate investments between extremes remains relevant in navigating the evolving landscape of the investment market.
