Are Index Funds Breaking the Stock Market? – The Irrelevant Investor

It's been a while since I've written about index funds because, honestly, what else is left to say? Not only has the topic been thoroughly discussed, but I also believe there are much more important elements when it comes to investing that will determine whether or not you will reach your financial goals. How to make sure you spend and save. They are where they need to be. How to maintain long-term investment when things are very scary. How to choose the right asset allocation. And how not to chase the newest shiny object and eventually follow the herd over the cliff.

I'm adding to the already overly large pile of articles on index funds because last week S&P released its 2023 report. SPIVA report, which shows how equity and fixed income funds have performed against their benchmark indices. Both in the short and long term, the numbers speak for themselves. This year's takeaway is the same almost every year: For most investors, index funds should remain the preferred investment option.

Before I continue, I want to say that I am a big proponent of index funds, but I am not a fan. While I recognize their merits and use them for our clients and myself, I also believe there are other strategies you can implement to achieve your financial goals, some of which we employ.

Twenty years ago there were 2,337 domestic stock mutual funds in its database. Only 34% of them still exist today. In other words, 66% is not.

We all know that it is very difficult to beat the stock market by picking individual stocks over long periods of time. We all know that finding managers who can do that is very difficult. And we all know that staying with those managers long-term can be the hardest thing of all.

Index funds aren't perfect, but you know exactly what you're getting; the performance of the index, net of fees.

I should point out that last year was an absurdly difficult time for stock pickers, particularly those who are benchmarked to the S&P 500. Fewer stocks have outperformed the S&P 500 in the last 12 months than at almost any other time since 1990. There's no chance of get over it if you weren't the same weight as the magnificent seven.

While index funds are one of the biggest innovations in finance, having created trillions of dollars in wealth for consumers, there is a reasonable case to be made that they are creating some strange dynamics in the market. This is an incredibly nuanced topic, far from black and white. You'll see in a second how I make a point that contradicts the previous one. I should also point out that others, notably Mike Green, have been at this for a while.

I shared a mind-blowing fact about The Compound and Friends this week. Over the past six sessions, Nvidia had added $61 billion in market capitalization on average, or $366 billion in total. Josh asked: “Who is the new Nvidia cash buyer right now? The dumbest moron on Wall Street?

My response was “The joke is that these are index funds. It's us." He was a little joking, a little serious.

Nvidia represents 5.3% of the S&P 500. Vanguard's S&P 500 funds*, plus Blackrock and State Street's S&P 500 tracking ETFs, have $2 trillion in total assets*. This is not to mention the trillions of dollars in other funds that track the index, the heavy weighting in the Nasdaq-100, as well as all the dollars allocated to target-date funds, which also hold trillions of dollars in assets. And money is coming into these things. relentlessly.

So are index funds the only reason Nvidia is going vertical? Hardly. I remember watching Charlie Ellis give a speech in which he talked about who sets the prices. It's true that index funds receive the most money, but they only do a small fraction of the total trading on any given day. Active managers set prices, index funds take them. Mostly. I say primarily covering Grand Rapids because I think they are probably impacting the prices of certain stocks more than others.

One area that is absolutely affected by index funds is which stocks are added to the basket. Take Super Micro Computers as an example of this. The stock rallied strongly throughout the year along with all semiconductor names. The stock has risen 300% in the past six months, catapulting it to the top holding in the Russell 2000 by a mile. Last week they announced that it will be added to the S&P 500, comically jumping the Midcap index and moving into the big leagues.

The stock gained 19% that day, and is now worth $64 billion! I don't know how much of this is due to the inclusion of the index, but it is probably more than 19%, as surely sophisticated traders could have suspected that this announcement was coming.

The chart below shows that technology is dominating the sector's fund flows in a hilarious way, and rightly so! These are the most dominant companies on the planet. They invent billion-dollar items, hundred-billion-dollar categories, and trillion-dollar industries. And they do it with higher, more stable and more protected margins than any other sector in the world. And naturally, their actions are rewarded for all of this. And then, naturally, investors pile in, driving up prices, perhaps someday sowing the seeds of their own demise. We'll see.

While many of these fund flows come from indexes that track sectors, I don't think they fall into the realm of "index funds are distorting markets." Reasonable people can argue about that statement.

Are index funds moving mega-cap stocks? I don't know, probably? But if they were the only thing that moved the magnificent 7, and I know no one goes that far, then how do you explain the recent price action in Apple, which is the second largest holding? It trades like shit because the news flow is not very good. Neither is the story of growth. Tesla is another. The stock is down 29% for the year, while the index is at all-time highs.

Now, here's the thing. So what? I don't want to trivialize a legitimately important topic, but what is the “and” here? Index funds are doing strange things in the market, which is why people should buy active mutual funds. Index funds are doing strange things in the market and should the government ban them?

I think it's pretty difficult to argue that index funds don't impact certain parts of the market. I also think it's pretty hard to argue that the negatives outweigh the positives.

Index funds are incredibly simple. This topic is the complete opposite.

*Vanguard number includes multiple share classes, including mutual funds and ETFs, VOO

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