Index fund "bubble" about to burst?

[PizzaSteve]

All this talk about index funds possibly distorting markets is a FUD campaign by high fee firms struggling to sustain market share.

There is no research or theory that holds water with any serious financial professionals.   Even active funds build diversified portfolios, roughly with similar processes to an index fund.  The net buying and selling among various investors, funds, executives exercising options, preferred shares being converted, etc, etc. provide plenty of activity.  There is always someone who thinks they know better than the market price, willing to buy or sell at an individual stock level, or  at a derivative level (futures, ETF options exercised, etc).

[Classical_Liberal]

Agree with PizzaSteve.  As an anecdotal example, look at what happened to the markets with the unexpected Trump victory.  Yes, the indexes moves slightly higher, but look at the movements within the indices, it was pretty substantial.  Way more flow & realignment of capital than the few percentage point shifts the indices saw.  Active traders remain very active, keeping a relatively efficient market.

[FIexec]

I think about 82% of the value of the US stock market is comprised of those largest 500 stocks.  That's from a pool of only ~4,000 stocks that mutual funds ultimate invest. 

Unless someone has some evidence available, I see no reason to believe the aggregate, active fund ownership of large-, mid-, and small-cap significantly deviates from market composition.

I would logically think that one would expect to see the exact behavior quoted, money moving from active funds (in aggregate) to the S&P 500.  Anything else (i.e., small-cap, mid-cap, or specific sectors, NOT VTI/VTSAX) likely WOULD distort the market!

[Classical_Liberal]

Anything else (i.e., small-cap, mid-cap, or specific sectors, NOT VTI/VTSAX) likely WOULD distort the market!

Wouldn't those who artificially weight investments in indices within specific market cap or industries be considered active (or at least semi-active) traders?  By definition, the efficient market would be in play and it would be the active traders "distorting" the market.

[Telecaster]

The fundamental problem with index funds is market cap weighting. Flows out of bond funds, and actively managed funds into S&P 500 based index funds that are concentrated into the largest companies.

The S&P 500 index by percentage:
10% allocation to  3 companies - AAPL, GOOG, MSFT
20% allocation to 10 companies - BRK, XOM, AMZN, JNJ, FB, GE, JPM
50% allocation to 50 companies

If 50% of the money flowing into index funds is used to buy shares in only 50 companies (32% by market cap are in the tech sector), what do you think the price of those shares are going to do? Index investors are not nearly as diversified as they think and it will come back to bite them sometime in the future. To see what you, as an index investor are really buying right now, take a look at the holdings of the etf XLG which holds the top 50 largest S&P components.

The funny thing is we had almost this exact same situation with the Nifty 50 back in the 1960's. It didn't turn out too well.

Assuming you are correct--and you could well be--there are a couple easy fixes.  One is to invest in VEXAX, which is the total stock market except the S&P 500.   Another, and likely complimentary fix is to invest in RSP, which is an S&P 500 equal weight index.  Boom!  Problem solved. 

An equal weight index will be more volatile, but volatility is your friend.  At least in the accumulation phase. 

[Retire-Canada]

Assuming you are correct--and you could well be--there are a couple easy fixes.  One is to invest in VEXAX, which is the total stock market except the S&P 500.   Another, and likely complimentary fix is to invest in RSP, which is an S&P 500 equal weight index.  Boom!  Problem solved. 

RSP has a MER of 0.4% vs. something like VTI = 0.05% so you are paying nearly ten times the cost to have equal weighting vs. the much more cost efficient market cap weighting. That's an expensive way to solve something that may not actually be a problem.

[Telecaster]

Assuming you are correct--and you could well be--there are a couple easy fixes.  One is to invest in VEXAX, which is the total stock market except the S&P 500.   Another, and likely complimentary fix is to invest in RSP, which is an S&P 500 equal weight index.  Boom!  Problem solved. 

RSP has a MER of 0.4% vs. something like VTI = 0.05% so you are paying nearly ten times the cost to have equal weighting vs. the much more cost efficient market cap weighting. That's an expensive way to solve something that may not actually be a problem.

Excellent point.    To be absolutely clear, I'm not advocating this position.  I'm merely pointing out that if you are concerned about index funds overweighting in certain stocks  then there are easy alternatives. 

That said, since inception RSP has beaten the S&P 500 index pretty handily (compared to VTI) . 

That said, you can look at RSP is basically mid-weight strategy.  So if you think the typical index is overweighted, and wanted to avoid the fees of RSP you could buy a mid-cap index, or maybe VEXAX as I suggested above.

[PAstash]

This is what I read when I read that article:
"There will be a market reset someday."   (Sure.  Of course there will)
"Some idiots will sell off their investments in a panic."  (Again: absolutely true.)
"A lot of those investments will be in index funds." (Yes, because index funds are a good chunk of what is being invested in.)
"And smart fund managers will see a lot of bargains out there when the index funds sell.  They will buy them."  (Yes.  That's what happens when stuff is cheap.  People with the cash will grab up all the bargains.)
"And therefore you should invest with managed funds."  (Um... that conclusion is really not supported by the above.)

All of this. A+