The Index Fund Problem Looming in 2024

I told you not to sell. I worry about it. A good.com. Do you happen to own index funds in your portfolio? Maybe SPY from State Street or VO from Vanguard or IVV from Black Rock? All these ETFs track the S&P 500, which is an index composed of the largest 500 companies in America. Whatever the S&P 500 gets, these ETFs get too, minus fees.

Now, this strategy is well known as passive investing. Not trying to beat the market, but just spreading your bets and accepting the average market return. Well, what if I told you there might be a major problem with this method of investing? One that could potentially be fueling the largest stock market bubble the world has ever seen. And I'm not the first one to talk about this either. Just last year, Michael Bar noted that the only difference between now and the year 2000 is the passive investing bubble that inflated steadily over the past decade.

So, what is this hypothesized passive investing bubble? And could it put our stock portfolios in danger? Well, let's get some context going. First, as I said, passive investing is the common stock market strategy of buying market-tracking index funds or ETFs and simply buying them periodically over a long period of time. For example, over the long run, the S&P 500 Index has averaged roughly 10% per year. So, passive investors, instead of trying to beat the market, accept that 10% is a pretty decent return, and they will pick one of these large S&P 500 index funds, accept the average, and hope that the future looks somewhat similar to the past. I'm not saying it will, but that's what they're hoping.

Also, if you'd like more information on exactly how you can implement this strategy, definitely check out Stock Market Investing for Beginners over on New Money Education. Now, there's also no secret that passive investing as a strategy has become incredibly popular over the past few decades. Interestingly, at the end of 2023, the total amount of money managed passively reached a combined total of 13.29%. This shows that people are switching onto the idea that most regular investors won't beat the market. This is a really good trend to see.

I mean, even if we look at the professionals, we can see that in America, 87% of actively managed funds did not beat the S&P 500 over the last 10 years. So, it's great to see that people are getting the message, rejecting the idea of giving your money over to some big asset manager who's likely going to underperform and charge you for it. But this enormous growth of popularity in passive investing also comes with its own issues, and one of them is that index funds are in a bit of a bubble.

Now, there are actually a few arguments here, and the first is specifically related to the S&P 500, which, if we're real, is what most passive investors are holding. It's no secret that we've heard a lot about the Magnificent Seven this year and last, and it's also no secret that these seven companies have been roaring ahead based on their future promise of AI goodness. But you know what's crazy? These seven companies now account for 32.749941% of the S&P 500. So, in other words, 1.4% of the businesses in the S&P 500 represent 13% of the index, and the other 98.6% of S&P 500 companies only equate to 2/3 of the index.

Nvidia alone is now over 6% of the S&P 500. That's wild, right? And I don't know about you, but for me, when I'm passive investing, my goal is to hedge my bets, to diversify, to make sure your portfolio doesn't get affected very much by one particular company. Well, now actually you've got a big stake in seven overvalued tech companies that have had their share prices artificially inflated thanks to the speculation around the future of AI.

Take this for example: if these seven tech stocks had a big AI tech crash and each dropped around 50%, the S&P 500, the index holding America's 500 largest companies, would fall around 16%. So, one of the big problems with these ETFs now is that despite passive investors looking to be widely diversified in the case of the S&P 500, they're actually more concentrated than ever before. More than ever, your stock portfolio is at the mercy of the stock movements of just a few really big companies.

So that's part one of the ETF bubble argument. Before we talk about part two, it is once again time for a quick update on Brandon's book club. As you guys know, this year I've been focusing on reading a lot more, and one of the strategies I use to ensure I make it as simple as possible for me to get my learning done is by using Blinkist, who have been sponsoring this channel throughout the whole year. So, if you don't know them, Blinkist summarizes a lot of non-fiction books and podcasts into quick 15-20 minute blinks, which helps you get to the key points really quickly. It also helps you decide if you want to go further and actually take the time to read the book in full.

This week, the blink that I was listening to was “Common Stocks and Uncommon Profits” by Philip A. Fisher, and I was surprised that despite this book first being published in 1956, the stuff in it still holds up today. The blink went through how to look for long-term growth potential, how to research a company including, of course, the classic scuttlebutt method, the inefficiencies of the stock market and how that opens up opportunities for the investor, and it even spoke about stock market psychology and how you need to think differently from the herd.

There are actually a lot of really great investing and finance books on Blinkist, as well as blinks on entrepreneurship and marketing, economics, communication, productivity, career and success, philosophy, and a whole lot more. So, I definitely recommend you join the now 31 million strong Blinkist community, and if you sign up with my link in the description box or the pinned comment or follow the QR code on screen, you'll get started with a 7-day free trial. If you like what you see, you can use those links to score 40% off Blinkist annual premium. So thanks very much to Blinkist for sponsoring. Check the link below to subscribe, and let's get back to the ETF bubble.

So, we spoke about the concentration of the market and the seven tech companies really inflating the S&P 500's market cap. But there is actually another contributor to this idea of a passive investing bubble, and it comes down to the nature of the strategy itself. You can think about what's going on when people invest passively. What are the goals of passive investors or index investors buying, say, the S&P 500? Well, their goal is to invest in the largest 500 companies in America on a regular schedule, no matter what's happening in the stock market or in the broader economy.

To expand this idea further, what this really means is that money is being invested in these companies regardless of their business performance. Think about it this way: if I look at Microsoft, for example, look at the top three largest shareholders. Number one isn't Bill Gates or Satya Nadella. It's Vanguard. Number two, it's Black Rock. Number three, State Street. Microsoft's largest shareholders are the big ETF providers, and together just those three companies hold $576 billion of Microsoft's $3.4 trillion market cap.

Now, in reality, these positions represent thousands and thousands of individual investors that simply own investment products like an S&P 500 Index Fund. This means that straight off the bat, 16% of Microsoft shares are held by investors who have bought the stock not because it's Microsoft, but because it's a company in the S&P 500. We can look at any company in the S&P 500 and the results will be the same. Proctor and Gamble? Top three holders: Vanguard, Black Rock, State Street. So, $78 billion of their $388 billion market cap, or 20% of their company, is just held passively.

Nvidia? Vanguard 1, Black Rock 2, State Street 4, 19.7% of their market cap. Etsy, at the other end of the S&P 500? Vanguard 1, Black Rock 2, VanE 3, and State Street 4. So, 28% of their shares outstanding. No matter where you look, these companies today have a lot of shareholders that have bought in without actually intending to invest in that stock specifically. This causes some market distortions.

This is what Michael Bar was referencing in his tweet that I mentioned at the start. His argument is that the rise of passive investing has removed price discovery from stocks. So, price discovery is the idea that the correct price of a particular stock will be naturally figured out by a market through supply and demand. But Bar's argument is that as soon as a stock gets caught up in an index, all of a sudden you have a lot more demand because now you have the passive investors that are blindly buying the business's shares because the company happens to fall in an index.

The idea is that as passive investing gets increasingly popular, this will continue to inflate the share prices of particularly the bigger companies in the market that do fall under the umbrella of a lot of passive investment products. Michael Bar noted to Bloomberg back in 2019 that passive investing has removed price discovery from equity markets. The simple theses and models that get people into sectors, factors, indexes, or ETFs, and mutual funds mimicking those strategies, these do not require the security level analysis that is required for true price discovery.

So, over time, more and more shares of these big notable companies are being held not because of the underlying business performance, but simply because they're in an index. Over time, this can lead to an overinflation of stock prices. And really, when you think about it, that's kind of the definition of a bubble, right? When prices inflate for reasons unrelated to the fundamental performance of the business. In 2000, it didn't matter what the fundamentals were doing, as long as the company was putting ".com" in its name, right? And it feels a little bit like that right now. You know, the fundamentals seem to be mattering less and less, and the narrative around AI is driving stock returns more.

So, there are a few arguments for this passive investing bubble, but I guess the question is, are we in any danger of popping? Well, firstly, it is worth noting that the current landscape is a little bit different to say that of 1999. For example, in 1999, you really had poor companies just hacking the system and seeing huge price gains by announcing grand internet plans, but you know the earnings weren't really moving. So, that's obviously a bubble. But today, while there is a lot of hype around AI, the interesting thing is that the earnings are actually moving up with stock prices.

So, take a look at this chart, for example: in Q1 of 2024, despite the stock prices of these tech businesses soaring year-over-year, earnings growth of Amazon, Google, Meta, Microsoft, and Nvidia rose by 64.3% compared to the other 495 companies in the S&P that saw an earnings reduction of 6%. So, while the market might be roaring, it is worth noting that the performance of these big behemoths is actually holding up.

But the other thing to consider from Michael Bar's tweet is what happens if sentiment changes and passive investors start leaving the market together. In his tweet from last year, he mentioned that all theaters are overcrowded, and the only way anyone can get out is by trampling each other, and the door is only so big. So, what does he mean by this? Well, let's quickly revisit how stock prices move. It's supply and demand, right? Because shares are traded between investors, you need buyers and sellers to make transactions go through.

So, if there are a lot of buyers and not a lot of sellers, the share prices rise, and vice versa. If you have a lot of sellers but not many buyers, then the share price will be set by the most desperate seller. Now, what Michael Bar is saying is that because of passive investing, there are a lot of shareholders that hold the stock without even really knowing why they're there. They just hold the stock because they're on some dollar-cost averaging plan.

So, suddenly there are a lot more people in the theater, but because every stock transaction still needs someone on the other side of the deal, Bar is concerned that if the market drops and spooks a lot of average Joe investors out of the market, you might have the situation where there's a lot of people trying to get out of the theaters. But in the stock market, for someone to leave the theater, you need to convince another person to come in.

So, if people in the overcrowded theater start to smell smoke and a certain number of people decide to head for the exit, well, it could cause a big crash in the share price because there simply won't be many people willing to come in and take your seat. So, because all the theaters are so overcrowded thanks to passive investors, this could eventuate to rapid declines in share prices across the board if something were to spook them out of the market.

So, that's one school of thought. However, there is another thing to think about, and that is that despite a lot of trading activity occurring in and out of these passive funds all the time, this actually doesn't translate to a massive amount of trading volume in those underlying companies that make up the index. That's because most of the trading of ETF shares happens on the secondary market, AKA passive investors simply trading back and forth with themselves. For example, Vanguard found that 94% of the time, the trading of ETFs was conducted on the secondary market.

So, for all that ETF trading volume, 94% of it didn't even touch the underlying stock positions that make up the ETF. But what about if there was a crash? What if there is a lot of selling all at once? Well, in those cases, ETF units do get created or destroyed, and that does cause trading in the underlying stocks. But interestingly, even when you consider the normal activity of creation and redemption, a study conducted by Black Rock in 2017 shows that it's still a very small fraction of overall trading. In fact, they described a case study of Apple, which was at that point the largest company in the world.

They noted that in July 2017, a month which saw large inflows into ETFs, $65.9 billion of Apple stock was traded. Although Apple was held by 331 ETFs globally, they found that at least 95% of the stock's trade volume in July 2017 was not directly related to ETF flows. Based on this data, there might be a case that the idea of a passive investing bubble might be a little bit overblown. I think there are concentration risks for sure, with the tech stocks representing 33% of the S&P 500 now, but it looks far less bubbly than, say, 1999.

It's difficult to say whether the rise of passive investing would even cause any significant market distortions if we saw widespread panic. But with that said, definitely let me know what you think down in the comment section below. Also, New Money Education is linked down in the description if you are interested in checking that out and learning how I go about my investing. But with that said, guys, please leave a like on this video if you did enjoy it. Subscribe if you'd like to see more, and I'll see you guys in the next video.