Andrew Hallam
26.05.23

Why The Popularity Of Index Funds Might Peak or Decline
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What would happen if everyone invested in index funds?

I get asked this a lot. But unlike most index fund fans, I don’t sugar coat my answer. If every penny in the markets were invested in index funds, we would have a broken market.

I’ll explain what would happen, using Apple.

Apple is currently the largest company in the S&P 500. As such, it’s the highest weighted stock in the index.

Now imagine this:

Apple’s CEO strips naked on national TV. He tells the world that the company just gave its entire portfolio of phone/computer/gadget patents to Samsung. He adds that Apple will abandon tech and enter the porn film industry.

If everything were invested in index funds, Apple’s share price wouldn’t fall, unless money coming out of the S&P 500 index exceeded money flowing in. In other words, Apple’s shares would rise or fall in line with the S&P 500, no matter what shenanigans the CEO pulled.

That’s because no active traders would sell Apple’s shares…because active traders wouldn’t exist. Apple could poop the bed every night. Yet, no matter how stinky its profits were, it would remain America’s largest company, based on market-cap.

Index funds and ETFs have soared in popularity. On the retail fund level, Americans now have more money invested in passive funds than they have invested in actively managed products.

Could actively managed funds follow the trajectory of cigarettes: going…going… going….and yet, never really gone?

A recent romp through Europe tells me cigarettes could be here to stay. Yes, we know they cause cancer. Yes, we know they wreck our teeth. But a surprising number of people still pick up smoking. And yet, nobody wins the London Marathon and credits their victory to a daily pack of Benson & Hedges.

In sharp contrast, however, you can bask in a windfall with a hot stock pick, a scorching mutual fund or a crypto-currency. And headlines tell us when such victories occur…much like red lights and bells after a casino jackpot win.

For example, a $10,000 investment in Cathie Wood’s ARK Innovation fund gained seven times its value from January 2017 to December 31, 2021.

From 1965-2022, Warren Buffett’s savvy stock picking helped Berkshire Hathaway average 19.8 percent per year. That would have turned $10,000 into a mind-blowing $387.5 million.

In 2008, when US stocks plunged 38 percent, Ray Dalio’s deft trades ensured investors in his Bridgewater Pure Alpha Fund gained 9.5 percent. In 2010, the fund soared a whopping 45 percent.

This is why active management will always look attractive.

There are also larger-than-life characters like Kevin O’Leary and Jim Cramer on Squawkbox (and every other business network) telling viewers what to buy and sell if they want to grow rich.

And much like smoking, chasing past and (supposedly) future winners can be addictive.

Active trading also makes huge money for our biggest banks. No, they don’t make money beating a portfolio of index funds. They earn their bread and butter charging others who believe they can. And it’s relatively easy to keep believers hooked.

American retail investors have more money invested in index funds than in actively managed products. But most of the money in the markets is held by institutions. And most of that money is actively managed. According to the Investment Company Institute, 84 percent of the money in the U.S. market is actively managed. What’s more, the percentage of active management in other countries’ markets is far higher than it is in the United States.

So active investing still dominates. And although passive investing has gained popularity among retail investors, that could soon reach a peak. That’s because plenty of investors buy index funds without understanding how the markets work. They bought index funds or ETFs because their friends or a Facebook group said it was the best way to invest.

Increasingly, I receive emails from readers thanking me. They say, “I made X amount of money since (name that year) so indexing works.” In many cases, when reading my books, they immediately flipped to the pages showing them “what to buy” instead of fully understanding why.

What many of them don’t know is that, even during down years, indexing works…whether they see gains or not.

It works because the aggregate return of the markets will always match the return of all actively managed money in that given market, before fees. After fees, passive wins. But investors who don’t understand that could easily be swayed. For example, since 2001, we haven’t had any multiple year stock market declines. When we do, advertisers for active management will push hard. The active funds that kept large sums in cash during multiple year declines will advertise that they beat the market.

That will rattle the index fund investors who don’t know how or why indexing really works. Many will then be lured by the promises of active management and the talking heads on TV.

But don’t be one of them.

And please…oh please, don’t smoke cigarettes.

Andrew Hallam is a Digital Nomad. He’s the bestselling author Balance: How to Invest and Spend for Happiness, Health and Wealth. He also wrote Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas

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