The Index Bubble

In the last two quarters we’ve examined the growing divergence between US Megacaps (S&P 500) and everything else. We concluded that this divergence was driven by non-sustainable sources of return and began to discuss the potential sources of divergence. While it’s tempting to point to the recent AI hype, this trend goes back a lot further and is better explained by a more subtle force: The rise of ETFs and other index trackers. By far the most tracked index in the world is the S&P 500 index. As investors have pulled money from other funds and invested them in S&P 500 trackers, there has been a wave of indiscriminate buying of the US Megacap stocks that comprise this index at the expense of everything else. This is evidenced by the fact that almost half of the S&P 500’s total return over the last decade has come from non-sustainable return, whereas US Midcaps, emerging markets and other developed markets have just kept pace with their sustainable return.

Passively managed funds now account for more than half of US assets under management, up from 20% in 2009. There is a lurking danger in this that probably won’t be exposed until the next major bear market. There is an old saying that ‘the bull goes up the stairs, but the bear goes out the window.’ The idea is that bull markets climb gradually, while bear markets fall very suddenly. As long as money continues to flow into equity markets in an orderly fashion, the dislocation being created by the dominance of index funds is likely to go relatively unnoticed. But what happens in the next bear market, when investors panic and decide they want to pull their money out of stocks?

With every redemption from an index fund, the exact same group of stocks that has been bought indiscriminately over time is likely to be sold indiscriminately in a much shorter space of time. And with the market dominated by index funds all facing the same wave of redemptions and all selling the same group of stocks, where is the liquidity going to come from on the buy side? Bear markets have always been characterized by a liquidity crunch where desperate sellers overwhelm reluctant buyers. If this has been the case in markets dominated by active investors with different portfolios/strategies and the ability to trade at their discretion, what will happen in a market dominated by passive investors all trying to sell the same stocks without the ability to exercise discretion? Might we see some breathtaking plunges in the prices of the most popular index constituents? Might we see a failure to meet redemption requests from some of these funds? Time will tell, but the risk is real and growing as indexation increasingly dominates the investment industry.

We believe there’s far more potential for good long-term returns in those neglected areas of the market that have often been indiscriminately sold in favor of the S&P 500 Index. We also believe there’s a lot less risk of the bottom falling out.