Are Index Funds Distorting the Stock Market? Don't Listen to the Critics

It's fashionable again to blame the humble index fund for all the world's ills.

Indexing has become a major global financial force as a form of passive investing that aims to match the market rather than outperform it. In the process, it has drawn the ire of some of the world's most famous investors.

The latest accusation is that passive investing has led the U.S. stock market to become obscenely concentrated in a handful of colossal tech stocks known as the “Magnificent Seven.”

Indexing has already been accused of inflating speculative bubbles, breaking financial markets, being un-American and undermining the principles of capital allocation essential to a market economy.

Fear not. Your index fund is not destroying capitalism. The accusations have never stood up to scrutiny, and neither does the latest round of accusations.

Critics of indexing tend to offer variations on the same theme: Passive funds don’t take into account the true value of a company. Instead, they mindlessly pour money into stocks based on their weighting in the index.

In 2016, asset management firm AllianceBernstein published a paper titled “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” It argued that passive markets are even worse at allocating capital than a planned economy.

Among the detractors are some of the biggest names in the investment world: Carl Icahn, Howard Marks, Seth Klarman, Cathie Wood, Michael Burry, Peter Lynch. A few months ago, the famous hedge fund investor David Einhorn declared that the passive investing boom had fundamentally broken financial markets.

Of course, the common thread among all these names, besides their success, is that they are all active investment managers.

The rhetoric has veered into the absurd. If you’re among the hordes of index fund converts, there’s a billionaire investor somewhere who thinks you’re more of a traitor than a trader.

Lately, the smear against indexing has been spreading to the general public. The June cover of Harpers magazine asked the question: Will passive investing be a disaster?

The argument goes that the bigger a stock is, the more passive money it attracts, which drives its stock price higher, creating a dangerous feedback loop. The proof is that seven tech giants—Apple Inc. APPL-Q, Amazon.com Inc. AMZN-Q, Alphabet Inc. GOOGL-Q, Meta Platforms Inc. META-Q, Microsoft Corp. MSFT-Q, Nvidia Corp. NVDA-Q and Tesla Inc. TSLA-Q—now make up about 30% of the S&P 500.

Profits at big tech companies have eclipsed those of the rest of the stock market

Magnificent Seven Stock Earnings Per Share (EPS) Growth Compared to Rest of the S&P 500

EPS Growth Index (2014 = 1)

*Annualized growth rate as of May 31, 2024

SOURCE: QUARTERLY GMO LETTER 2nd quarter 2024

Big tech companies' profits have been eclipsed

the rest of the stock market

Magnificent Seven Stock Earnings Per Share (EPS) Growth Compared to Rest of the S&P 500

EPS Growth Index (2014 = 1)

*Annualized growth rate as of May 31, 2024

SOURCE: QUARTERLY GMO LETTER 2nd quarter 2024

Profits at big tech companies have eclipsed those of the rest of the stock market

Magnificent Seven Stock Earnings Per Share (EPS) Growth Compared to Rest of the S&P 500

EPS Growth Index (2014 = 1)

*Annualized growth rate as of May 31, 2024

SOURCE: GMO QUARTERLY LETTER 2nd quarter 2024

But there’s a very good reason why big tech companies have been gobbling up the stock market, and it has little to do with index funds, Boston-based asset manager GMO noted in the latest edition of its widely read quarterly investment letter. Over the past decade or so, the Magnificent Seven have collectively generated earnings growth of nearly 20% per year, according to the report. The other 493 names? 4.1%.

It is business fundamentals that are driving the technology frenzy, not corruption caused by passive investment.

The impact of passive investing on markets has been overstated, writes Ben Inker, co-head of asset allocation at GMO. He adds that indexing cannot, as its critics claim, change the basic mathematics of investing.

But passive investing has, as Mr. Inker admits, undeniably reshaped the investing landscape over the past two decades.

At the root of this upheaval are two eternal truths that have struck the investing masses. First, it is extremely difficult to beat the market, even for professionals, and it is nearly impossible to do so consistently. And second, investment fees are silent portfolio killers.

The passive approach, in its purest form, seeks not to pick market winners but rather to replicate the performance of the entire market at the lowest possible cost. Today, a Canadian investor can buy, with a few clicks of a mouse, an exchange-traded fund that approximates the S&P/TSX Composite Index while charging a minuscule management expense ratio of 0.05%.

Over the past 20 years, similar products have attracted trillions of dollars worldwide, at the expense of active strategies. Globally, passive funds now dominate capital flows, controlling about 40% of ETF and retail mutual fund assets, according to data compiled by PWL Capital as of the end of 2023.

This is a monumental transfer of wealth that many in the industrial sector have vehemently resisted.

The impact of indexing on prices, however, is more plausible when it comes to small-cap and value stocks, which have indeed been very out of favor for years, according to GMO. But even here, the effect is limited to the timing of returns, not their final level.

If value stocks trade at too large a discount to the market, with money being moved into passive vehicles, value stocks will outperform going forward, Inker writes.

In other words, if the indexation movement has given rise to price distortions in the stock market, that is exactly the kind of thing that an active and intelligent investor should be happy to exploit.