I'll first clarify what this article is NOT, because some confusion is possible. This article is not an argument (for or against) about whether individual mutual fund investors should invest in index funds or ETFs. That's not the topic of this article at all. Investing in these passive funds is a decision that investors should take based on normal investing logic. We're talking about something different here.
There's a new article in the American magazine 'The Atlantic', rather provocatively titled 'Could Index Funds Be 'Worse Than Marxism'?' Actually, that's a doubly provocative title because it will provoke two different kinds of people in two different ways but I'm bothered by only one of those. The idea behind the article is something that is seeing an increasing discussion amongst a diverse set of people who think about investing carefully. Some of these are academics, some are investors and some are analysts of one kind or another.
The idea is that when it grows too dominant, passive investing has a range of negative impacts that are marketwide or even economy-wide. This effect is emerging not over years but over decades but eventually becomes dominant. One of the fundamental functions of a market is that it selects between the good and the bad and does so based on the view of the future that investors take collectively. The worry is that with the dominance of passively managed funds, that is no longer happening.
As this article dramatically puts it: With index funds, nobody's behind the scenes, dumping bad investments and selecting good ones. Nobody's making a bet on shorting Tesla or going long on Apple. Nobody's hedging Europe and plowing money into Vietnam. Nobody is doing much of anything at all. These funds are "passively managed," in investor-speak. They generally buy and sell stocks when those stocks enter or exit indices, such as the S&P 500, and size their holdings according to metrics such as market value. Index funds mirror the market, in other words, rather than trying to pick winners and losers within it.
When index funds become dominant, their success becomes a self-fulfilling prophecy. The set of stocks in the indices do well because they are in the index. The indices do well because those are the stocks that get bought. From the standpoint of the individual investor in these funds, this is fine. Their investment returns are fine.
However, from a larger perspective, that of the entire economic system, the main function of the equity markets is to allocate capital to businesses that will do well and deallocate it from businesses that will not. Instead, in a passive-dominated market, the main activity becomes that of allocating capital to businesses to whom capital is already allocated. It sounds like nonsense, and at some scale it can well make the markets nonsensical.
The question is, how far are we from that point when the movements of the market become a self-reinforcing system? In the US, they might be quite close to it. In fact, some time before he died, the father of the passive investing revolution Jack Bogle himself said, "I do not believe that such concentration would serve the national interest," referring to the likelihood that more than half of all US stock may soon end up being owned by index funds.
How far are we from index funds achieving that kind of dominance in India? The answer is that it's complicated. On the face of it, passive funds are a minor force in India. Bogle was referring more to the fact that index funds ownership is tending to dominate the corporate ownership of many large companies. In India, this effect could arrive quite early because of the growing dominance of the EPFO's inflows into the large indices. Moreover, compared to the US where a 500 stock index is dominant, we have the Nifty and the Sensex which are tiny and very top-heavy. This is already creating an ever more powerful self-reinforcing effect in a small number of stocks. The inflows from the EPFO are growing continuously and are quite predictable. They are already an important fraction of the flows into a fairly small number of stocks. In effect, they form a floor under the prices of these stocks. The distortion from this will become more and more pronounced as time goes by.
Again, this is not something that should have an impact on our investment decisions right now, but it's a trend that could end up becoming a huge problem.