Zweig on the Impact of Index Funds

Last month marked the fortieth birthday of the first index fund (launched by John Bogle, founder of the Vanguard Group) and the anniversary has triggered a lot of discussion and reflection on the trajectory this class of funds has traveled since. Jason Zweig of the Wall Street Journal shares some thoughts on the subject and how the phrase “too much of a good thing” could apply.

Zweig reports that over the past year $409 billion has flowed into index funds, a class of funds that “slash the costs of investing by 90% or more by skipping most of the research and trading their human rivals engage in.” However, while lower costs are definitely appealing to investors, a potential problem could arise from this market dynamic. Zweig refers to last month’s report by investment firm Sanford Bernstein that warns, “index funds might grow to the point at which new investments could be massively mispriced.”

The point, Zweig writes, is that index funds (which own essentially all the stocks or bonds in a benchmark “basket”) don’t set prices but rather “accept the prices that active investors have already set,” and refers to the funds as “autopilot portfolios.” The Bernstein report argues that if businesses are to raise capital by selling shares, “you need a deep market of active investors willing to take a view on the valuation of the company.” Index fund investing, Zweig explains, doesn’t contribute to that effort.

According to Zweig, Bogle himself agrees that “passive investing can get too big for anybody’s good” but says it would have to account for at least 90% of the market to cause real chaos.

Note: A subsequent article by WSJ columnist and editor Holman Jenkins Jr. states that less than a quarter of all investor dollars are currently held by index funds.