Index Funds for the Long Haul? Why Some Pros Are Nervous

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We unquestioningly repeat the knowledge that index funds are the easiest way to “passively” build wealth. But what happens when too many investors go passive? Is this the most “benevolent bubble” in history? (Fair warning: That description is hyperbolic.) In this week’s solo expedition, I attempt to make sense of these claims—and what it would mean if they’re true.

(I am not a licensed financial professional, I’m just a podcaster with internet access, so please do your own due dil.)

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Our show is a production of Morning Brew and is produced by Henah Velez and Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is President of Morning Brew content and additional fact checking comes from Scott Wilson.

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Mentioned in the Episode

• “What Goes Up” by Andrew Lipstein (Harper’s Magazine)

• “Market Efficiency is Not the Question” episode with Michael Green (Rational Reminder)

• “How Competitive is the Stock Market?” paper (Valentin Haddad, Paul Hueber, Eric Loualiche)

• “Are Index Funds a Bubble?” (JL Collins)

• “For Your Information” (Michael Green)

• 2019’s SECURE Act 2.0 (IRS.gov)

• Bogleheads forum

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Katie:

If you listen to financial podcasts like this one, or hell you even attended your company’s benefits presentation about your 401(k) plan options, chances are that you are now well aware of a supposed truth in financial markets: The safest place to invest your money is in broad, diversified, low cost index funds, right? It’s such boring anodyne advice against a backdrop of meme, stocks and crypto as to barely register as a novel idea.

I alluded at the end of our episode about social security that index funds might be a pyramid scheme of their own. And this was of course meant as a lighthearted joke, but every joke possesses a tiny glint of reality. So naturally and regrettably, this prompted a flurry of panicked listener emails from people who apparently listened to this show to the very end, thanks. And I decided that this concept that the mass reliance on and faith in passive investing might be concealing a more complicated reality about markets than we are collectively ready to metabolize. I think that’s worth a closer look.

Welcome back to the Money with Katie Show. As always, I’m Katie Gatti Tassin, and today we are breaking down the theories and arguments that index fund investing might just be the most “benevolent bubble” in history. So perhaps you’ve seen these arguments before in my internet trolling to make sense of this theory. It occurred to me that it produces some interesting implications about markets more generally.

So that’s where we’re going to end today, but I’m going to ask you to briefly suspend your disbelief over the next half hour or so in order to entertain this idea, because your confirmation bias is going to absolutely hate it. I know mine did, but as index investing becomes ever more popular, I think you are probably only going to continue to hear about this more.

The toughest paradox that we’re going to face in this journey together today is the harsh reality that there is literally nothing you as an individual investor can do about this. So I suppose I’ll spoil my own lede before we even really get started. Nothing I’m going to say today is going to change the fact that it is still in your best interest to continue investing passively in index funds.

And with that said, I’m not a licensed financial professional. I’m a podcaster with internet access. So my goal is to break down the concerns about passive investing so that you’ll have a fuller appreciation for what might be happening in markets right now. I think it provides an interesting lens to use. We’re going to get into the arguments, the counter arguments, the conversation I think it opens us up to more broadly, which effectively boils down to an eventual Marxist revolution. I don’t know. I know I say this a lot, but buckle up.

Okay, so to begin today, what is passive investing? Why do we call it passive? Tell me if this process sounds familiar to you: You should invest in an index fund that tracks the largest companies. You should then put money in on a regular cadence without any regard for what the market is doing. And that the more you can ignore what’s happening and just shovel money in the better. And then by doing so, your money’s going to compound. You’re probably going to average real returns around 7% every year over time. Okay, great. Congratulations. You’re done. Anyone? Anyone?

We heard this before, these index funds, and let’s be real. Usually when we say index funds, this is synonymous with US Total Stock Market or S&P 500 funds, which comprise a cap weighted collection of companies allow you to invest in all of the big US companies with a single click.

Obviously this advice is alluring for a few reasons. It doesn’t really require knowing anything. It is an incredibly low effort way to get rich. And in many ways that is the entire value proposition. And because so few active managers have historically been able to outperform this average cap weighted index of the total market, it’s a double whammy because not only are you likely to get solid returns over time with effectively no effort, but there really isn’t a better alternative because the alternative is overpaying for someone who is probably going to underperform the average. So when we refer to passive investing strategies, those are the broad strokes of what we are talking about and we’re going to get right back to it after a quick break.

So understandably, this value proposition has made index fund investing incredibly popular, and estimates of the passive money in the market right now do vary widely. But experts put passive investing share of the total US stock market between 15% and 38%. Vanguard has more than $13 trillion in passive investments, or put another way money that is just holding up a mirror to the market and reflecting the average of that market.

So for a long time, this reflection, again intended to capture the average, was considered a separate force from the market itself. Like the market’s going to do its thing thanks to all these traders who are making these calculated bets. And this mirror world of passive investing is just going to go on reflecting whatever the active side of that market does. But after a while, the thinking goes, if enough people are just reflecting the market and they’re not actively trading in it, the amount of money in the reflection is going to surpass the market itself or otherwise known as the very thing it is trying to mirror.

And this belies a fundamental truth that has actually been true all along. Passive investing has always been the market. It’s not a separate reflection of the average, it is the market. But now thanks to some recent increases in volatility, some people, most famously the investor Michael Green, we’re going to be talking more about his theories today. We’ve talked about him on the show before. They’re beginning to wonder if it’s perhaps reaching a tipping point or the point at which the reflection is overpowering the very thing it is supposed to reflect. And obviously that is going to have some negative downstream consequences.

So again, I want to state very plainly that at a high level, all of the statements that I made before that are in favor of index fund investing, that best practices process, they have been true and it’s still true today. And the advice that we have deduced that, hey, just dollar cost average into low cost index funds, that has been historically excellent advice. But when you poke and prod at the concept a little bit more, I don’t know, I started to feel like the cracks might’ve been hiding in plain sight the entire time.

So let’s talk about some of those cracks. When you dollar cost average into an S&P 500 index fund for 40 years, unbeknownst to you, you are behaving in a way that is called “valuation insensitive.” This basically just means you’re not looking at higher prices and thinking, I don’t think Tesla is really worth all the other car companies combined. That doesn’t make any sense. No. Per my advice and the advice of practically every other personal finance fund it again based on good data, based on history, you’re just going to insensitively allocate new capital to that index fund, which is of course going to continue to plow ever more money into an already overvalued Tesla.

So this is kind of the basis of the theory. And so you as a psychologically flawed human, you’re going to see high prices and prices continuing to go up, and you’re actually probably going to assume that that means things are going really well.

But this is where the distortion can begin to happen according to this theory that when a stock’s price increases its market capitalization, so the size of the company gets bigger, and as the market cap gets bigger, it takes up a larger share of the index because again, the index is cap weighted. And so then as it takes up a larger share of the index, now every new dollar that is added to that index is going to go into that company, which makes it even bigger. So this leads to a market that is broadly speaking, top heavy and overvalued that is essentially the core of this argument.

And so in fact, for a while, a stock’s price would rise temporarily after being added to an index simply because being in that index meant that everyone investing in the index is now buying that stock. This effect has lessened in recent years per Andrew Lipstein’s reporting for Harper’s, but it illustrates the broad concern with this idea of price insensitivity and index fund investors are price insensitive, okay. So you might start to think that the issue with this price insensitivity thing is market efficiency. That okay, if there are fewer nerds with eight screens that are trying to identify arbitrage opportunities, markets are just going to be less efficient. And that’s an issue. And okay, I guess that is probably true, but some experts like Michael Green and his camp would warn that the real problem is market inelasticity. It’s a market that is less able to absorb shocks.

So combine this knowledge with the fact that the description buy and hold is a little bit of an obvious misnomer because nobody holds forever. Eventually you’re going to sell even if that’s only to realize your gains and use your money. So this problem that I’ve kind of been building up to of what would cause this whole thing to unravel, when do these top heavy valuations become a problem?

The problem would theoretically occur from too many people selling at one time. So here is the general theoretical proposition for how a sort of index fund black swan bubble would burst the market for whatever reason, takes a plunge. People start selling and withdrawing their money from Vanguard’s S&P 500 index fund, and at first it’s not a big deal. A little money’s moving around, but once outflows surpass a certain point, and that point is to my knowledge also theoretically unknown, more shares need to be sold to meet the cash demands of those people that are trying to remove their money. So it’s a little bit like a run on a bank. And because to our earlier metaphor about the reflection in the mirror, these index funds being the reflection because they’re so large, they can theoretically, again, I feel like I’m going to say that word every 10 seconds in this episode, they can theoretically move markets. If enough people sell, you get this sort of downward spiral where the price starts to go down, which prompts more selling and so on and so forth. Amen.

So this aforementioned Michael Green fellow who has been the loudest and most strident critic of our country’s reliance on index funds as the retirement plan for most Americans, points out that these giant asset managers like a vanguard, right? They hold so little cash that shares would have to be sold to meet the demand of this sort of massive outflow.

And so it kind of reminds me a little bit honestly of that story. I heard you probably heard it too a couple of years ago about the Winklevoss twins, the Winklevoss boys who apparently own so much Bitcoin that they actually can’t, they couldn’t sell it all at once and cash out their cash because if they sold it all the price would crash because they own so much of it. It’s a little bit like that.

So a counterargument here, friend of the show, JL Collins, he wrote that, hey, active management is not going to do much better. They have like 5% cash on hand in reserves, so that would be nowhere near enough to prevent this from happening. So he basically says, this will happen during crashes regardless of the size of passive markets, but it’s not just a crash that could theoretically cause this toppling Here is where our previous birth rate panic episode dovetails nicely. We love that nice synergy in the show.

Your standard lifestyle model of investment behavior coupled with generations of investors who are decreasing in size could trigger such an event put simply as the baby boomers who own a shit ton of the stock market, well, they’re retiring, they start spending down their assets, they’re spending their money. So theoretically their outflows or the investments that they’re selling to get cash to live on could begin.

And this I think is the main concern that people are really worried about, could begin outpacing the inflows, the money coming into those markets of the Zoomers and younger, the people that are going to be funneling their stagnant wages into the market. And this again, in theory, is a concern if you want to put it even more simply this in elasticity, it functions to magnify whatever is happening. So what would ordinarily be readily absorbable? Little moves in either direction are amplified into wild swings. And you know what, that point about wage stagnation, it’s very important.

Since wages are growing so much slower than capital, you get this extra layer because the capital in people’s 401(k) plans is ballooning. It’s getting bigger, much bigger than wages are getting bigger and retirees withdrawals. The outflows from these very markets from these funds are based on their asset levels. You’re going to take out 4% each year theoretically. So as that capital balloons, those withdrawals can keep getting nominally bigger. But since contributions or inflows are based on a percentage of your wages, which are largely stagnant by comparison, you are almost guaranteed in this theoretical framework to see outflows outpace inflows, even if population size never starts shrinking. So it’s interesting because it kind of ties this problem of wage stagnation to market and elasticity overall.

That’s enough for now. Take a 30-second break, guys. Take a lap. We’re going to continue after a quick break.

Okay. So where does this idea come from at this point? I would say the most compelling and popular work on this topic comes from a guy that we’ve been talking about a lot already in this episode, the intimidatingly brilliant, Michael Green. I basically understand every third word that he says, but in a recent interview for Harper’s journalist Andrew Lipstein described Green’s affect as being slightly reminiscent of deer in the headlights, but Green is the headlights. So basically all of the explanation that I have laid out up until this point has come from work that Green has done, and by basically me just consuming a ton of everything he has said on this topic, there was actually even some very exciting smart guy beef between Michael Green and another financial egghead (celebratory) named Ben Felix, who I have an intellectual crush on. We’ve talked about Ben before on the show in which Green basically penned this Substack diss track about Felix’s handwaving away of index fund bubble concerns.

But unlike Kendrick and Drake, Felix did not strike back with seven more diss tracks. He just invited Green on his little podcast for a civil chat. So I’m about to throw out a lot of jargon, but hang on tight.

Okay, so Ben Felix is a noted value investor. He believes in the work of these two dudes, Eugene Fama and Ken French in 2007, Fama and French basically postulated that the binary comparison of active and passive is misleading because some active managers are morons. That’s an industry term. If active managers who are bad at their jobs AKA their trading is actually making things less efficient, if they switch to passive, ironically market efficiency improves. Okay, so this is kind of the explanation that Ben Felix takes and is like, yeah, that makes sense. If we’re worried about efficiency, then as long as only the good active investors are sticking around, then we shouldn’t have anything to worry about.

But this is where Green would swoop in and did swoop in and said, hey, efficiency is not the concern. Inelasticity and volatility are the concern. And the challenge he says is that the typical pushback that you hear against these passive concerns is that well, as more people shift passive, there’s going to be even more opportunity, right? There’s going to be more active managers who are ready to take advantage of that passivity and make active trades and trade against it. But he says that that relies on something called the Grossman-Stiglitz Paradox, which is basically a fancy financial theory name for the wisdom of crowds. And the problem is that as passive gets bigger and bigger and bigger, it makes up so much of the crowd that it basically drowns out the other traders, the active traders. He says that as passive gets larger, it becomes harder and harder to trade against it. Here’s Green explaining that to Barry Ritholtz.

Michael Green:

What’s actually happening is we’re giving more and more of a vote to somebody who doesn’t care. As a result, Vanguard and BlackRock, because of their daily transactions, the size of those transactions has gotten to the point, even though they’re not actively trading on a day-to-day basis, that relentless bid that your partner refers to is actually changing the structure of the market. It’s changing that price behavior.

Katie:

So right, the magic question, how big would passive markets have to get in order for this to happen? I guess I would say the answer is maybe nobody knows. I’m sure there is some quant out there who has identified this point, but you probably saw headlines at the end of last year because at the end of last year, something did finally happen. Total US passive investments, whether in mutual funds or ETFs, controlled more of the market than actively managed funds did, which is partially why we are all going to be experiencing an uptick in this conversation about this index fund bubble tipping point.

So you might be like, oh, okay. Yeah. So at the end of 2023 funds and passive investments, they surpassed actively managed funds. That must be because of that valiantly misguided work of one Katie Gatti Tassin and her team at the Money with Katie Show. I wish as much as it would be easy and a little fun and spicy to blame personal finance hobbyists with ill begotten access to podcasting equipment, it’s actually far more likely that the quote culprit is way bigger. The feds. That’s right. It’s the feds baby.

You see, here’s the point in the episode where we are transitioning from the economic and markets theory to policy. So all the assholes in the comments who are going to tell me to stick to money and stop being political, you’re going to want to pause this episode and leave your one star review now.

But I’ve said it before and I’ll say it again. Money is and has always been political. And by that I mean impacted by policy and of the people. This is a perfect example of why is true. We exist in an interesting time in American capitalism where things have become so unequal and cutthroat that the continued survival of the system relies on everyone continuing to believe that as the pie gets bigger, we can keep privatizing more and more of it and leave it up to markets and competition to allocate that pie properly.

I mean, think about it. Our entire model for money rests upon this assumption being true. You work for 40 years, you save and invest diligently. You fund your own retirement, and you’re going to need that money for literally everything because basically everything is sold to you by a for-profit company, aided and abetted by the strength and power of our federal government. All in the name of what else? Efficiency. With the exception of social security, we have almost totally privatized pensions and income for the retired in the form of the 401(k) and other similar plans.

So Lipstein writes, quote, “The advent of the 401(k) plan set in motion by the Revenue Act of 1978 gave workers a tax-deferred savings account linked to their employer and helped funnel money from pension plans in which employees continue to collect income after they retire into retirement plans where savings are accrued before retirement and invested in securities like stocks end.”

Alright. So you might be like, well, what’s the difference? Why would pension plans have been any better? Right. Well, the pension plans of yesteryear were often managed by hedge funds who were making active bets while 401(k) plans are invested in index funds for the most part, we shifted so much of society’s capital into these individually managed vehicles. And what do you know, most individual wage workers do not have the time, energy, or intel to actively trade their retirement funds and they shouldn’t be. To be fair, I would not recommend that.

But the end result is that vast sums of money are invested in these behemoth index funds instead people’s life savings. So exacerbating matters was another measure of policy that we often celebrate in the personal finance space as a good thing for savers. I bet you know what, it’s automatic enrollment.

Michael Green:

Things that we think of as having always been there, things like 401(k)s and IRAs are actually very recent inventions, and there’ve been dramatic changes around their implementation within your investment career and my investment career, which are roughly similar in duration.

Ritholtz:

It actually predates us but had not become popular like it had existed for about 20 years before people start to figure out, wait, I could put this money away and have it grow tax free. It really took a few decades before the market came to grips with that.

Michael Green:

Yeah, I mean, so just very quickly, IRAs were created in 1972 to facilitate a key risk that nobody had ever imagined before, which is if you were a union employee who was fired in the 1971 recession and you received a lump sum settlement of your pension, you suddenly that was treated as earned income in that year. You were subject to the 75% marginal tax rate. It was absolutely insane and devastating to many individuals. And so the IRA was created to facilitate the rollover of those on a tax deferred basis so that you could maintain those assets even if you lost your job, right?

The second tool that was introduced was the 401(k), which refers to a specific provision of the tax code that created the defined contribution. If you launch yourself all the way back to 1981 in the start of the bull market, 1982, the start of the bull market in US equities following the election of Reagan, the total assets in those two were about a hundred billion dollars in each, right? Today IRAs I believe are around $17T, and 401(k)s are somewhere in the neighborhood of $8 to $9 trillion, right? These are the single largest pools of assets on the planet is the American retirement system.

Katie:

That’s Green in conversation with Ritholtz, again, explaining how these vehicles came into existence and consequently shifted the nature of flows into the market. In 2006, the Pension Protection Act made 401(k) participation an opt out, not an opt in thing. So rather than asking a worker to opt in, now the worker is automatically opted in unless they choose to opt out.

Now, the charitable interpretation of this move is that, oh, the government’s just trying to nudge people toward better savings behavior, right? And in 2019 as part of the Secure Act 2.0. the government increased these incentives. But you can’t help but notice once you begin using Green’s lens, that predictably these changes have the coincidental effect of increasing inflows. So his theory, which again, perhaps cynical, but I don’t know, not unlikely, is that this was passed to stave off 401(k) outflows as the giant incredibly rich boomer generation started retiring and pulling money out. In other words, to subtly force new money to keep coming in to avoid the problem that I spent like the first half of this episode describing.

So I don’t know, maybe now my pyramid scheme joke makes a little bit more sense. Something like 95 cents of every dollar that’s invested for retirement goes into a target date fund.

So what’s that sound? Can you hear that coming down the road, it’s the part of every episode where I rail against neoliberalism. Alright. So again, it might be cynical, but to point out that the government is now effectively requiring more money to flow into passive funds via 401(k) enrollment might be just, might be a signal that there is at least some recognition from the US state that passive investing cannot fail; its failure would be tantamount to society’s entire model of working and retirement collapsing.

So there was a line in Lipstein’s piece for Harper’s that really jumped out at me. He said, “The failure of passive investing would strip away every last pretense that the market is a collective good. Underneath that idealistic veil in the broad daylight of a new epoch, we’d see the base unit of investing the trade for exactly what it is an exchange that two parties sit on opposite sides of, each hoping that the other got the worst end of the deal.” So think about it this way, in our current late stage capitalism regime, the bad news is excessive inequality threadbare social safety nets, right? But the supposed good news that is intended to offset those suboptimal realities is the prize we apparently win for putting up with the US basically being the nation state equivalent of a knockoff Gucci belt. This idea that with enough pluck and grit and hard work and access to the magic of the market, anyone can become rich, right, by dollar cost averaging into the stock market. Oh my God, it’s so easy that markets are an effective way, the most effective way to organize the things that everyone needs most in society, like funding the retirements of every old person, the ease and success, at least success up until this point, it is still so far successful of passive investing is the linchpin on which that entire premise rests.

As Lipstein writes, it’s the last pretense that markets are a collective good. And hold my beer. What if they’re not? Just entertain that for a moment. What if this entire debacle is revealing the uncomfortable underlying truth that markets require winners and losers and passive investing is predicated on what else? The idea that everyone can be a winner, right? Everyone can win, but if everyone’s winning, it’s no longer a market.

So I’ve talked on the show before about how I often feel really conflicted morally about my aggressive participation in the stock market given my, I don’t know, for lack of a better word, like class consciousness, about how these companies that I am personally profiting from are extracting those profits from a workforce that is underpaid. And the one psychological saving grace that often rescued me from this hand ringing was this idea that, well, if everyone just invests and participates, if we can just help every single person invest in these companies too, if we can make everyone a shareholder, then everyone can be a winner and like, oh good. What an amazing thing that there is this magically easy way to become rich via index funds. It’s not zero sum. The pie’s going to get bigger, everyone’s slice is going to get bigger, and my profiting from their underpaid labor is not really at a cost to them.

But that logic all relies on the existing laws of the market. It says nothing else needs to change. We just got to get more people in. And as even the wage stagnation element of this equation proves a society that continuously funnels wealth upward in both its population and its markets will on paper at least eventually become too top heavy and topple over. Again, say it with me theoretically.

So yeah, I assume by now I have sufficiently freaked you out. Or maybe if you’re not freaked out, you’re like, she’s a conspiracy theorist. So I’m just going to say this. I am still investing in index funds. This does not change my personal investment decisions at all. Green himself says that that is the only rational choice that you have. Seeing as a Black swan event of that nature might never happen. Not everything that’s true in theory happens in practice. And if it does happen, it might not happen in your lifetime.

Michael Green:

There’s very little, the individual or the individual RIA can do to change this. This is a regulatory framework and it is controlled by the Vanguards and the BlackRocks who are spending far more on lobbying than the rest of the industry combined, right? So part of what’s really happening is the political choice to push you into these vehicles. The political choice to make it the only acceptable alternative under the rubric of offering safe, low cost investments to people is totally understandable. We all want that desire. Certainly that’s your desire as well.

Katie:

The thing is, we just don’t know what the future holds. We don’t know what might change or if these theories that make sense in mathematical proofs would actually occur in real life in this way. And the challenge of conversations like these is that they confront us with compelling economic theories that call our entire paradigm into question, but they ultimately don’t produce a viable alternative path because of the correlation of all of these markets. There’s really no asset class that would be safe from such a catastrophic event. For example, if passive investing crashed, it’s not like real estate would fare any better because a substantial portion of the so-called on paper wealth of US society would basically vanish, which kind of puts everybody in the same boat.

And as someone on the Bogle Heads forum put it, “Ask your friends and acquaintances how many of them are fully indexed because if you’re like me, none of them will be.” Their point is just that we kind of exist in a sort of echo chamber here that occurs in personal finance circles like this one where we assume that everybody is doing this.

And so yes, while the data is compelling, it’s maybe not as common as we would think, or I may have led you to believe over the last hour. So for now, Vanguardageddon is probably still a really long way off if it’s going to happen at all. But for now, I hope you have at least enjoyed a little bit this deep dive into why some people are worried about the economic index fund tipping point. And now the next time that you see an article about it, hopefully you’re going to have a little bit more context as to what they are talking about.

Okay, that is all for this week, and I’ll see you next week on the Money with Katie Show. We are going to follow up this theoretical deep dive with something nice and tactical, setting up money management systems for the short and long-term. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact checking comes from Scott Wilson.