Are Passive Funds Creating an Index Bubble?

Over the past several years there has been a significant shift of capital out of actively managed funds and into passive funds that track indices such as the FTSE 100, FTSE All-Share or S&P 500, to name just a few. The shift has come from both institutional and individuals investing online into pensions and other investment portfolios. In the USA, the share of capital under management allocated to index trackers has risen from 20% to 40% in under ten years. In 2017, 90% of net inflows to asset managers were to passive funds, accounting for $1 billion a day. In the UK the pattern has been very similar.

The arguments for passive funds are clear, especially from the point of view of a retail investor. Active fund managers haven’t consistently demonstrated the ability to beat benchmark indices and they charge handsomely for the privilege of often underperforming passive indices. Of course, some active fund managers do beat the benchmarks consistently but they are few and far between. For retail investors, the risk to reward ratio of managing to bet on a winning active manager is a questionable one. Experts advising retail investors have also largely thrown their weight behind the passive index investment approach.

However, the capital swing towards passive index investing involves some longer term danger that could end up hurting returns. Most of the biggest indices, such as the FTSE 100, S&P 500, Nasdaq etc. are weighted by size. The larger the market capitalisation of the company, the greater respective share of the capital invested into the index goes into its stock. The larger companies get the largest share of the money flow and this compounds over time.

The concern is that this will lead to market distortion that will have consequences for investors. The way money flows to companies through passive investing means the biggest companies are getting bigger and the smaller companies growing less. The smallest constituents of big indices such as the S&P 500 are even starting to shrink as the market capitalisation gap widens.

This growing top heaviness of indices has two clear consequences. It reduces the risk spread for investors as the biggest handful of companies increase their weighting within the index. It also leads to big companies growing in value based on their original weighting in the index rather than necessarily strong fundamentals. Capital discrimination based on the underlying quality of businesses is dropping. Ignoring fundamentals in this way is what ultimately leads to bubbles. This may not happen for some time yet but for those investing online and heavily exposed to the big indices it is an ongoing process which could well come home to roost at some point.