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Here’s Why Small Investors Aren’t Buying the ‘Index Funds Bubble’ Argument

September 28, 2019, 10:00 AM UTC

You may have heard the ever-louder debate recently emanating from the world of Big Finance on whether equity index funds and ETFs are heading for a bubble. Small investors, like families saving for college or retirement, are also weighing in on the matter—and their response seems to be an indifferent shrug of the shoulders.

The debate reignited this month after Michael Burry—who made a fortune betting against toxic securities during the financial crisis, then gained fame when Christian Bale portrayed him in 2015’s “The Big Short“—compared index funds to the collateralized debt obligations (CDOs) stuffed with subprime mortgages that, in 2008, nearly sent the global economy into a death spiral.

“This fundamental concept is the same one that resulted in the market meltdowns in 2008,” Burry told Bloomberg, noting that “it will be ugly” when the reckoning finally comes. “Like most bubbles, the longer it goes on, the worse the crash will be.”

A few days after that stern warning, investment research firm Morningstar announced a startling insight: U.S. stock index funds and ETFs, often called passive funds, now hold more assets than the more traditional mutual funds that are actively managed by a fund manager. Passive funds made up 50.2% of the U.S. stock mutual-fund pie, while actively managed funds made up 49.8%.

Symbolically, it was a big deal for the centuries-old mutual fund industry.

Passive funds are a relatively recent innovation. In 1976, John Bogle introduced the first index fund, which is now called the Vanguard 500 Index Fund. Back then, Bogle’s humble little fund was met with a mix of indifference and scorn on its debut, with some calling it “Bogle’s folly,” and Fidelity mocking it for pursuing “average returns.” The whole point of managed mutual funds, after all, was to beat the market.

But a funny thing has happened since Vanguard set up its first index fund: Most active funds have underperformed the broader market over the past 20 years, while continuing to charge investors high fees for the privilege. Meanwhile, the Vanguard 500 Index Fund how has nearly half a trillion dollars in assets under management.

Stock-picking is not dead

In the $9.2 trillion market for U.S. mutual funds, stock-picking may not exactly be a dying art, but it looks to be an increasingly sidelined one. For large and small investors alike, the average performance of stock index funds is more than good enough, provided it comes with minimal fees.

“Investors are pocketing more of their hard-earned savings than ever before,” says Ben Johnson, director of global ETF research at Morningstar. “They’re investing that money for themselves, rather than forking it over to active managers, the majority of which have either failed to survive or failed to deliver the returns that are better than what they could have gotten through a low-cost index fund.”

Passive funds began to gain popularity in the 1990s with the introduction of ETFs, or exchange traded funds, which were as easy to trade as stocks while still offering low fees. It also coincided with the rise of the Internet, and the explosion of finance-related websites that allowed amateur investors to compare and contrast the performance of funds.

After the financial crisis, small investors began taking to the savings that low fees offered. The higher fees of active funds compound, like interest, over the years, eating significantly into investment returns. Bogle called this trend the “tyranny of compounding costs.”

In time, all of this tainted the allure of active funds, as did their underperformance against market benchmarks. Morningstar says that only 23% of all active funds topped the average of their passive rivals over the 10-year period that ended in June, 2019. Better performance through lower costs became too irresistible a deal for many investors to pass up. Word spread into the mainstream, thanks to shows like HBO’s Last Week Tonight, which explained it all in clear, humorous detail.

“There’s a growing disillusionment among many investors with active management,” Johnson says. “It’s not that they haven’t proven that they can deliver outperformance. It’s that most of the outperformance that they generate as a group gets eaten up by fees.”

Data vs. doom-mongering

That hasn’t sat well with mutual-fund managers, not to mention hedge funds that typically charge a management fee of 2% per year, plus a “performance fee” equal to 20% of any profits above a predefined benchmark. Before Burry, other big names running big investment funds had publicly griped about passive funds.

“Passive investing is in danger of devouring capitalism,” Paul Singer, the founder of Elliott Management, said in 2017. Pershing Square Capital’s Bill Ackman said in 2016 that, while index funds weren’t yet in a bubble, their growth “shares similar characteristics with other market bubbles.” And a year before that, Carl Icahn slammed Blackrock’s burgeoning ETF business. “There is no liquidity,” he said. “That’s what’s going to blow this up.” Each dire warning was followed by more inflows into index funds and ETFs.

The data doesn’t yet bear out the doom-mongering. Of the households that owned mutual funds, only 36% held at least one equity index mutual fund in 2018, according to the Investment Company Institute. Index funds make up between 14% and 18% of the U.S. stock market. And because many index funds take a buy-and-hold stance, their share of U.S. stock trading volumes is even lower, between 5% and 10%, Johnson estimates.

“Does that make for a bubble? I don’t believe so,” says Sam Huszczo, who owns SGH Wealth Management in Detroit and who says his clients’ attitudes reflect a lack of concern about a passive-fund bubble. “I haven’t had a single client bring this up. I honestly feel like this is more of a subject in the financial industry. It hasn’t dribbled down to the general public.”

That’s not to say that passive funds may not one day become so wildly popular that they won’t pose a threat to the overall market. It’s just not clear we’re at that point now—or even close to it. Instead, the biggest threat passive funds pose is to fee-reliant funds. According to Bloomberg, index funds and ETFs produce only $11 billion in fees a year by charging an average fee around 0.1%. Mutual funds generate $120 billion in annual fee revenue, while hedge funds take in $45 billion.

“Is there a point where this could go too far, where the tail could be wagging the dog? Yes, of course. But I think we’re still a very long way off from that,” Johnson says. “The danger is chiefly one faced by Wall Street: That they’re going to get paid less and become less relevant over time. If anyone is in peril, it’s largely the people who have been vociferous, oftentimes shrill, about the rise of indexing.”

Risks during down markets

To be sure, index funds and ETFs come with their own shortcomings. Smaller, niche funds can be illiquid during selloffs, making them more volatile as investors rush to trim portfolios. And as Huszczo points out, there are always investors who want to chase outperformance, and for them the higher fees charged by a proven fund manager may be worth it. Most broad-based index funds won’t offer that outperformance.

A paper released last week by five Federal Reserve researchers took a comprehensive look at potential risks of passive funds. They found that some did risk amplifying market volatility. But those funds were specialized ones—leveraged funds or “inverse” ETFs (designed to rise when markets fall)—that prudent investors are often advised to avoid.

More mainstream funds, however, can reduce liquidity risks in the stock market as well as the risk of cash redemptions when markets are stressed, the paper said. What’s more, the Fed researchers looked at outflows during the financial crisis and found that money flowed in to passive funds in 2008 and early 2009, while flowing out of active funds.

“The net flows of passive funds may be less reactive to poor returns and their growth may be beneficial for financial stability,” the authors wrote. Take that, doom-mongers.

A bigger worry the Fed mentioned is the shareholder-voting power quietly amassing in the hands of the three passive-fund giants: Vanguard, Blackrock, and State Street Corp. The more shares their index funds and ETFs buy, the bigger vote they have during shareholder meetings. Others have expressed concern about governance issues this trend could pose in the near future—including the man who started it all.

In an op-ed he penned only a few months before his death in January, John Bogle wrote, “If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation… It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the ‘Big Three’ might own 30% or more of the U.S. stock market—effective control. I do not believe that such concentration would serve the national interest.”

Of course, the moment Bogle predicted has already come to pass. But for families and others seeking higher returns in a market where such returns seem to be growing increasingly scarce, that may not feel like an immediate concern. Passive funds remain an attractive portfolio strategy—a low-cost, simple means to “set it and forget it.” And that’s unlikely to change any time soon.