If Everyone Bought Index Funds

Editors Note: This article was republished with permission from The BigLaw Investor

Recently, Robert Shiller gave an interview on CNBC where he questioned the value of indexing investing and expressed particular concern should 100% of the market move to indexes. What would happen if everyone invested in index funds? Let’s explore that idea.

Robert Shiller is a Nobel-prize winning economist famous for, among other things, developing the Shiller P/E ratio (also known as CAPE) which takes the average earnings of a company over the last decade to smooth out the impact of business cycles and other events to give a better picture of a company’s sustainable earning power. He’s a smart guy that thinks Bitcoin is a bubble. But when it comes to index investing, I’ve got a few questions.

The interview (three-minute video below) raises the following questions:

  • What happens if 100% of investors are invested in index funds?
  • Are passive index investors getting a “free ride” on other people’s work?
  • Why didn’t they talk about index investing 100 years ago?
  • Has passive investing been a bad thing for the market?
  • Was the strength of the country build by people who had opinions on the price of stocks?

100% Invested In Index Funds and Free Riding

If 100% of investors owned an index fund, we’d be in a pretty awful situation. Why? Because, we need the active investors to buy and sell stocks to set the price for the various securities. The index funds mostly just track the market capitalization. We can’t know the market capitalization unless an active trader is out there deciding which companies are worth more than others.

But should we fear a coming time when there are no active investors? Not if you’re familiar with the Gotrocks Family. That’s because as long as we have a stock market, we WILL have active traders trying to beat the market.

If the market becomes less efficient as more investors shift to index funds, it only increases the likelihood that some investors will shift to active investing to take advantage of the inefficiency. Plus, do you see people like Warren Buffett and Carl Icahn switching to index funds? They’ll continue doing what they do best and will be happy to pounce if a company’s valuation gets out of whack.

For that reason, I can’t see any scenario where the market becomes 100% index investors. And how many active investors do you really need to set the market prices? Not that many. We only need enough to make sure the market is setting prices efficiently. As long as we have hedge funds, pension funds and Ivy League endowments, we should be fine.