Are Index Funds Breaking the Stock Market?

I haven’t written about index funds in a long time because, honestly, what’s left to say anymore? Not only has the topic been thoroughly dissected, but I also think there are far more important items when it comes to investing that will determine whether or not you achieve your financial goals. Like making sure your spending and saving. are where they need to be. Like staying invested over the long term when things are really scary. Like choosing the right asset allocation. And like not chasing the newest shiny object and eventually following the herd over the cliff.

I’m adding to the already too large pile of index fund articles because S&P just last week released their 2023 SPIVA report, which shows how equity and fixed income funds have performed versus their benchmarks.   Over both the short and long term, the numbers speak for themselves. The takeaway this year is the same takeaway almost every year: for most investors, index funds should remain the preferred investment choice.

Before I go any further, I want to say that I am an enormous advocate for index funds, but I’m not a zealot. While I recognize their merits and use them for our clients and myself, I also believe there are other strategies you can implement to achieve your financial goals, some of which we employ.

There were 2337 domestic equity mutual funds in their database twenty years ago. Only 34% of them still exist today. Said differently, 66% are not.

We all know that outperforming the stock market by selecting individual stocks over long periods of time is very difficult. We all know that finding the managers that can do that is very difficult. And we all know that staying with those managers over the long term might be the hardest thing of all.

Index funds aren’t perfect, but you know exactly what you’re getting; the return of the index, net of fees.

I have to point out that last year was an absurdly difficult time for stock pickers, particularly those that are benchmarked to the S&P 500. Fewer stocks have outperformed the S&P 500 over the last 12 months than almost any other point since 1990. You had virtually no shot at outperforming if you were anything other than equal-weight the magnificent seven.

While index funds are one of the greatest innovations in finance, having created trillions of dollars in wealth for consumers, there is a reasonable case to be made that they’re creating some funky dynamics in the market. This is an incredibly nuanced topic, far from black or white. You’ll see in a second as I make one point that contradicts the prior one. I should also note that others, most notably Mike Green, have been all over this for a while.

I shared a mind-bending data point on The Compound and Friends this week. Over the last six sessions, Nvidia had added $61 billion in market cap on average, or $366 billion in total. Josh asked, “Who’s the fresh cash buyer of Nvidia right now? The dumbest asshole on Wall Street?”

My response was “The joke is it’s index funds. It’s us.” I was kinda kidding, kinda serious.

Nvidia is 5.3% of the S&P 500. Vanguard’s S&P 500 funds*, plus Blackrock and State Street’s S&P 500 tracking ETFs, have $2 trillion in total assets*. This is to say nothing of the trillions of dollars in other funds that track the index, the large weighting in the Nasdaq-100, as well as all the dollars allocated to target-date funds, which also hold trillions of dollars in assets. And money is coming into these things relentlessly.

So are index funds the only reason why Nvidia is going vertical? Hardly. I remember seeing Charlie Ellis give a speech where he was talking about who sets prices. It’s true that index funds are taking in most of the money, but they’re only doing a small fraction of the overall trading on any given day. Active managers set prices, index funds take them. Mostly. I say mostly as a Grand Rapids hedge because I believe they’re probably impacting prices in certain stocks more than others.

One area that is absolutely impacted by index funds is which stocks get added to the basket. Take Super Micro Computers as the poster child for this. The stock was rallying hard all year alongside all the semiconductor names. The stock is up 300% over the last six months, catapulting it to the largest holding in the Russell 2000 by a mile. Last week they announced that it’s being added to the S&P 500, comically skipping right past the Midcap index and moving into the big leagues.

The stock gained 19% that day, and they’re now sitting on equity worth $64 billion! I don’t know how much of this is due to index inclusion, but it’s probably more than 19%, as surely sophisticated traders could have suspected this announcement was coming.

This next chart shows that tech is dominating sector fund flows in a hilarious fashion, and for good reason! These are the most dominant businesses on the planet. They invent billion-dollar items, hundred-billion-dollar categories, and trillion-dollar industries. And they do so with higher, more stable, and more protected margins than any other sector in the world. And so naturally, their stocks are rewarded for all of this. And then naturally, investors pile in, pushing the prices higher, perhaps one day sewing the seeds of their own demise. We’ll see.

While many of these fund flows are from indexes that track sectors, I don’t think they fall within the purview of “index funds are distorting the markets.” Reasonable people can argue about that statement.

Are index funds moving megacap stocks? I don’t know, probably? But if they were the only thing moving the magnificent 7, and I know nobody is going that far, then how do you explain the price-action recently in Apple, which is the second-largest holding. It’s trading like crap because the news flow isn’t great. Neither is the growth story. Tesla’s another one. The stock is down 29% on the year while the index is at all-time highs.

Now, here’s the thing. So what? I don’t mean to trivialize a legitimately important topic, but like, what’s the “and” here? Index funds are doing weird things to the market, and so people should buy active mutual funds? Index funds are doing weird things to the market, and government should ban them?

I think it’s pretty hard to argue that index funds do not impact certain parts of the market. I also think it’s pretty hard to argue that the negatives outweigh the positives.

Index funds are incredibly simple. This topic is anything but.

*Vanguard’s number includes multiple share classes, including mutual funds and the ETF, VOO