Jason Zweig
Index funds are often hailed for their low fees, solid performance and transparency.
Could they also be destabilizing the markets—and undermining the very diversification they have long promised?
Recently, leading investing experts—including Rodney Sullivan, editor of the Financial Analysts Journal, consultant James Xiong of Morningstar Investment Management and Jeffrey Wurgler, a finance professor at New York University—have been warning that index funds could destabilize the financial markets.
The rise of trading in index funds, these researchers say, is causing stocks to move more tightly together than ever before—as if they “have joined a new school of fish,” as Prof. Wurgler puts it. That is reducing the power of diversification and could make booms and busts more likely and more extreme.
Unlike conventional funds run by highly paid stock-pickers who seek to buy the best securities and avoid the worst, index funds—including most exchange-traded funds, or ETFs—effectively buy and hold all the securities in a market benchmark such as the Standard & Poor’s 500-stock index.
According to James Bianco of Bianco Research, 2011 was a particularly rotten year for stock pickers: Only 17% of more than 4,000 funds that invest in large U.S. stocks beat their benchmark. In most years, fewer than half do.
Considering that index funds charge annual fees about one-10th of those levied by actively managed funds, it isn’t any wonder indexing has become a money magnet. A decade ago, 278 index mutual funds and 119 exchange-traded funds held $347 billion, or about 16% of all assets in U.S. stock funds. Today, according to Morningstar, 336 index funds and 1,148 ETFs hold $1.24 trillion, or fully one-third of all the money in U.S. stock funds.
That worries some analysts. “Markets work best when people think and act independently, not all together,” Mr. Sullivan says. When investors add money to an index fund, it generally will buy every security in the market that it tracks—hundreds, sometimes thousands at a time, regardless of price. When investors pull money out, the index fund has to sell across the board.
“These index-trading behaviors,” Mr. Sullivan says, “could interact with some unexpected event to cause significant and outsize consequences.” (Disclosure: Mr. Sullivan and I coedited a book about the value investor Benjamin Graham that was published in 2010.)
Analyzing how closely the returns of U.S. stocks moved up or down together, Mr. Sullivan found that this correlation has roughly quadrupled since the mid-1990s—coinciding with the rise of index-fund trading.
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