[bluGill]

The risk is because index funds don't do stock analysis (instead they buy and hold all stocks) they will invest in bad companies and prop their price up. Then when the bad company goes bankrupt (as everyone paying attention knows will happen) the index funds are left holding all the stock suddenly worth nothing.

Which is to say the traditional more expensive managed funds that actually pay attention to the fundamentals of the companies they invest in should see a comeback. While this style of fund is more expensive (because a human can only examine a few companies in a year in enough detail to decide if they are worth investing in - as a full time job you can maybe do 50) by investing only in companies that will do better than average they can beat the market (or shorting if you want to play companies that will do far worse than average). So far the low costs of index funds have made them a better investment despite them not investing in strong companies, but we should see the day where a managed fund can beat the index funds just because the index funds are leaving the advantages of analysis on the table.

You can argue [meaning this might or might not be correct] that historically managed funds have done worse than index funds because there are so many managers that anytime there is a slight deal someone jumps on it before the deal is large enough to pay for the costs of finding it. However if you don't jump on it someone else will and they make something on the deal while you make nothing. Thus as index funds take over there will be more and more deals for the managers to find, and managers can wait until they are large enough to be worth the price.

It will be interesting to see when/where the line is crossed.

[joshgel]

I think this is almost true. It would be true if index funds held all the stock. But since they don't and managed funds still exist, the stock price will go down when managed funds decide to sell. When the stock price goes down, the shares become a lower fraction of the index, so the index funds will also sell some.

I think the main point is that index funds still rely on traditional market players to effectively allocate risk. And as index funds take up more of the market, they become less able to do that. Right?

[toast0]

The index fund doesn't need to take any action to respond to price movement. When the stock price goes down, the shares become a lower fraction of the index and also a lower fraction of the fund's holdings.

The fund has to manage holdings around fund purchases and redemptions, and when the index changes.

[mruts]

This is not exactly true. Many (most?) indices are market cap weighted, so if a company’s stock is tanking (i.e, their market cap proportional to other tickers in the index is going down), the index will sell the shares.

In my view, index funds aren’t really passive at all, they are crowdsourcing the best ideas of active management. This is why many indices (like S&P 500) produce pretty good returns.

If you created an index held every US equity in equal proportions, regardless of price movement, that would be like what you’re talking.

If you compared the returns of the S&P 500 against this theoretical index (let’s make it an ETF and call it “DUMB”), you would find that the S&P 500 would have much better returns.

The takeaway from this is that many indices produce stellar returns and aren’t as “passive” as one might think. Think of factor indices or whatever.

[nostrademons]

The point is that the stock won't always tank when they're doing something that'll negatively affect fundamentals, because too few people are actively researching & investing in the stock to affect the price. And then when a tipping point is reached and the stock price starts to go down, index funds will exacerbate the slide as they rebalance out of the falling stock and sell off its shares.

Normally markets remain efficient because they provide an incentive for people to actively research & surface all available information on a company's future prospects. If most people aren't doing this, then a.) the market price will be slower to react to bad information about the company and b.) people who do actively react will make larger profits, as they can trade on their information before the majority of the market takes it into account.

There's an equilibrium level of disequilibrium - as more people pursue passive investing, returns to active investors rise, until some of those passive investors realize they can make large profits as active investors, restore market efficiency, and destroy the profit potential of active investing. I'm not sure exactly where we are in that cycle, but there's some evidence that stock prices have become less volatile overall except for major news-related panics, which would be expected if a large proportion of people are passively investing.

[jandrese]

The caveat is that doing active management can get expensive in a hurry, which is why traditional funds tend to underperform index funds. It's cheaper to have some simple rules that a computer can execute and occasionally eat losses than it is to hire a bunch of experts to do tons of work to avoid those losses and end up costing more than you would have lost.

Ultimately the problem domain of monitoring every publicly traded company and prognosticating their actions is huge, and the job is so messy that it will never be cheap. There should be an information theory paper on this somewhere.