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Are index funds bad for the stock market?

Index funds have become a popular investment choice due to their broad market exposure, maximum diversification, and minimal costs. The consensus is that everyone should invest in index funds.

This prevailing thought is supported by the fact that low-cost index funds typically outperform most active funds, where managers try to select the best stocks, over time.

However, if index funds are beneficial for individual investors, what happens when everyone starts investing in them? Does everyone benefit equally?

This brings us to a concept in logic known as the fallacy of composition. It’s a critical question for every investor, especially the general public.

Some argue that the surge in index fund popularity is contributing to one of Wall Street’s riskiest features: the massive overconcentration of the S&P 500, and the market at large, into a few megacap stocks like Apple (AAPL), Nvidia (NVDA), and Microsoft (MSFT).

The growth of index funds is staggering. In 1993, passive funds (i.e., index funds) invested in U.S. stocks managed $23 billion in assets, accounting for 3.7% of the combined assets managed by active and passive funds and 0.44% of the U.S. stock market. By 2021, passive assets had skyrocketed to $8.4 trillion, representing 53% of the combined assets and 16% of the stock market.

 
Investors buying index funds
 

In 30 years, the percentage of mutual fund money in passive funds has jumped from 3.7% to 53%.

The real shift is even more significant because many remaining active U.S. mutual funds are becoming “closet indexers,” closely tracking the indexes. The growth of passive investing is estimated to be more than double when accounting for the increasing tendency of active funds and other investors to stay close to their benchmark indexes.

This trend is accelerating the dominance of “megacap” firms, particularly those that are likely overvalued or ambitiously priced.

“Flows into passive funds disproportionately raise the stock prices of the economy’s largest firms, especially those large firms that the market overvalues,” experts say. One reason is that it reduces the potential pool of active investors who can hold less than the market weighting in these stocks, as well as the pool who can short the stock.

Even if you don’t fully embrace this viewpoint, it’s clear that index funds must, by definition, invest the most dollars in the largest stocks in the index, which are typically the most popular.

Currently, the “Magnificent Six” alone account for about one-third of the entire S&P 500 by assets. If you invest $100 in an S&P 500 index fund, about $32 is concentrated in just six companies. How’s that for diversification?

This dynamic makes the S&P 500 more of a short-term trading game rather than a long-term investing strategy. As the S&P 500 rises, more people invest in index funds. The funds then invest more money into the largest stocks, pushing their prices higher. This cycle excites others, leading them to invest in index funds as well.

“High prices bring out the buyers,” notes the fund company Leuthold Group in its latest research. Leuthold observes that while U.S. consumer expectations for the economy are low, their expectations for stock market returns are extremely high. This, even as the S&P 500 trades at levels relative to various earnings measures that are associated with previous market peaks like those in 2021 and 2000.

This doesn’t necessarily mean you should sell your S&P 500 index fund, as timing the market is notoriously difficult. However, it does suggest that diversifying your portfolio with midcap and small-cap stock funds, such as those tracking the S&P 400 mid cap index and the S&P 600 small cap index, can be beneficial. Alternatively, you might consider funds that invest equally in each stock. Low-cost options include the Invesco S&P 500 Equal Weight ETF (RSP), which charges 0.2% annually, and the iShares MSCI U.S.A. Equal Weight ETF (EUSA), which charges 0.09%.

 
 





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