digest
Short Summary
Main recommendation: Ben Felix argues that index funds are not creating a bubble or distorting price discovery, so investors should not abandon indexing over that concern. He also suggests that, whether or not index funds are distorting prices, investors should consider tilting portfolios away from large cap growth stocks and toward small cap value stocks.
Key Points
- Price discovery is driven by trading, not by how many assets are held in index funds; Vanguard's 2018 paper estimated about 5% of total trading is done by index strategies.
- Most ETF trading (about 94% on average, per Vanguard) happens on the secondary market between unit holders, without touching the underlying securities.
- BlackRock estimated that for every $1 of stock trades placed by index funds, about $22 of trades are placed by active managers.
- The Grossman-Stiglitz paradox, from Sanford Grossman and Joseph Stiglitz's 1980 paper, explains that markets exist in an equilibrium state—if indexing caused mispricing, active managers would have an incentive to exploit it, pushing prices back toward efficiency.
- Growth in indexing may be pushing out unskilled active managers and lowering short-selling costs through securities lending revenue, both of which could make markets more efficient, according to Fama-French and Palia-Sokolinski research.
Details Worth Noting
- Concrete instructions: Felix suggests underweighting large cap growth stocks and overweighting small cap value stocks in a portfolio. He notes this is sensible under either scenario: if the market is pricing correctly, small value has higher expected returns; if index funds are distorting prices, small value is underpriced and large growth overpriced. No specific amounts, percentages, or timing were given.
- Felix cites headline figures that index funds own about half of US fund assets, but Bogle's book put index ownership of the US stock market at about 15% in 2018 versus 3.3% in 2002.
- A 2017 BlackRock study estimated index strategies made up 17.5% of the global market including institutional and internal indexing, but only 7.4% when counting just index funds.
- Small cap value underperformed large cap growth for over a decade, but Felix notes a similar stretch in the late 1990s ended when small cap value reclaimed its lead after the tech crash.
- Felix argues assets under management do not set prices; the relevant measure is the share of trading done by index funds.
Bottom Line
The index fund bubble concern rests on a misreading of how prices are set: trading, not asset size, drives price discovery, and active managers still do the vast majority of it, so a small-cap value tilt is the practical takeaway regardless.
