Index Funds Transform Investment Landscape

The Wall Street Journal reported yesterday that a new study suggests that index funds account for 23.1 percent of all 401k fund balances (read the full article here; subscription may be required).

The study by BrightScope, a financial information company, reviewed 35,000 Federal Form 5500s that 401k plans are required to file each year with the Department of Labor, from 2012, the most recently available data.

As of 2012, 401k plans had $4.4 trillion dollars of investment assets, half of which are held in mutual funds. On average, plans offer around 25 choices – 13 stock funds, three bond funds and six target date funds.

The percentage of assets held in index funds is up sharply from the previous study in 2006, when 16.9 percent of all assets were held in mutual funds. In rough terms, I estimate that the shift represents more than $250 billion in new assets for indexers and lost potential assets for active managers.

I don’t have the numbers, but it’s quite possible that active managers didn’t actually lose assets because the overall pie grew enough to offset the lost market share, it’s hard to say.

There are many implications that come from a major shift like this and the first one that came to my mind was: what if everybody indexed?

Theoretically, indexing doesn’t work if everyone indexes because the market needs active managers to set prices.

Imagine a pharmaceutical company develops a new drug that the FDA approves. The market will set a new, higher price on the news. Instead of being worth $10 per share, the stock is now worth, say, $50 per share because an active manager is willing to pay more for the stock because of the news and another active manager won’t sell because the stock is now more valuable.

A lot of indexers bash active managers, but in truth, the indexer needs the active manager to set prices – markets won’t work without lots of competitive analysts scouring the market for news that will affect the value of the companies they own, buy or sell.

Indexers have a great gig because indexers get the collective analysis of all market participants for free – the clients of the active managers pay the freight. Unfortunately for those clients, the work that the active managers do isn’t hasn’t been worth the cost in additional returns and passive funds have outperformed on average, over time.

As substantial users of index funds (and other passively managed vehicles), should we be worried about the dying active managers that do us the great favor of keeping markets efficient?

Nope, not one bit, in my view.

In theory, a relatively small number of market participants can set prices.

I don’t know how many professional investors there are in the world today, but there are 118,847 Chartered Financial Analyst (CFA) charter-holders worldwide, according to the CFA Institute website. (I’m ashamed to say that I’m not one of them, but extremely proud to say that we’ve got four CFA charter-holders at Acropolis and one CFA charter-holder candidate).

Even if the world were limited to the existing number of CFA charter-holders, that’s a lot of people available to set prices. Even if they represented just one percent of the assets, they could set prices for the other 99 percent.

Realistically, there isn’t much of a chance that it would even come to that anyway. Although indexing is catching on with individual investors, 401ks are just one subset of the overall investment universe, including pensions (public and private), insurance companies, savings institutions, hedge funds, sovereign wealth funds, endowments, and foundations – not to mention other accounts that individual investors hold like trusts and IRAs.

Still, the trend towards indexing is powerful. We’ve been using index funds in the form of exchange traded funds (ETFs) since our founding a dozen years ago and think that the benefits are substantial.

I suspect that investors will continue to increase their allocations to index funds, but there’s virtually no risk that markets will become less efficient anytime soon because of the shift.