Indulging in Index Investing: A Sweet Treat or Too Much of a Good Thing?

INDEX INVESTING

Reflecting on childhood moments of overindulgence in sweet treats often elicits nostalgic smiles. Yet, it also brings forth the memory of that point when delight turned into discomfort – ever had too much chocolate?

Curiously, a similar narrative of excessiveness can be drawn in the world of investments, particularly with the advent of index funds—the equivalent of a bowl brimming with index-flavoured ice cream. Astonishingly, upon their inception, there were voices decrying index funds as ‘un-American’, dismissing the notion of simply tracking the market rather than striving to outperform it.

Since their introduction in the 1970s, index funds have emerged as indispensable tools in any prudent investor’s arsenal. They offer a tantalizing blend of affordability, diversification, accessibility, and market-mirroring returns. Numerous studies, including the reputable SPIVA® report, have underscored the consistent failure of actively managed funds to surpass their market benchmarks over extended periods. 

In fact, the 2023 SPIVA® report for the US revealed that a staggering 97% of equity funds fell short of this elusive goal over a 20-year span. Low-cost index investing, such as the one recommended by the Capital team, is a flavour of success that’s hard to resist!

But, is there such a thing as having too much of a good thing when it comes to index investing? The concern often raised is whether excessive reliance on indexing could undermine the efficiency of markets, predicated on timely price discovery. 

Essentially, the fear is that if everyone were to index, markets might lose their ability to accurately reflect available information, leading to chaos, as John C. Bogle, the visionary behind index mutual funds and founder of Vanguard, eloquently put it.

Bogle envisioned a hypothetical scenario where market efficiency would be compromised if indexing reached a saturation point, suggesting a delicate balance where active management still plays a vital role in price discovery. His estimation of perhaps 90% indexing and 10% active management as the tipping point implies that even with the widespread adoption of index funds, active investors would still drive a significant portion of trades.

But, are we nearing this tipping point? Data from the Investment Company Institute Factbook 2023 suggests index funds accounted for approximately 45% of the mutual fund market by the end of 2022, a notable increase from 22% in 2012. 

However, assessing the full extent of indexing proves challenging, given the diverse array of players, from institutional investors to not-for-profits, utilising indexing strategies beyond traditional mutual funds.

A recent innovative study attempted to shed light on this conundrum by examining the trading volumes on index reconstitution days, providing insights into the proportion of the market indexed across various categories. Their findings suggest a lower bound of 33% and possibly closer to 40% of the market being indexed, a figure well below Bogle’s hypothetical threshold of concern.

As we continue to appreciate the benefits of index investing, it’s important to maintain a balanced perspective. While data suggests a significant increase in the use of index funds, we’re still some distance from a point of excess. 

The key is to strike a delicate balance between indexing and active management, ensuring that markets remain efficient and functional. This nuanced view allows us to enjoy our scoop of index-flavoured ice cream while remaining vigilant about the portion size to avoid unwanted market indigestion!

Tim Hale

Albion Strategic Consulting

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