We are in the midst of the longest stock market expansion and these have prompted many experts and investors to speculate when will we see it to “take a break” or even crash. There are multiple reasons for these 10+ years of bull market, but my conjecture is that the index fund has played a major role.
There are many advantages in index fund investing over actively managed funds; low management fees and time tested superior performances just to name a couple. However, too much of anything doesn’t always yield good result and we might be approaching a point where the backlash could blindsight us.
Compared to actively managed funds, index funds use a simple strategy where it tracks a predefined list of securities. These funds will invest in financial securities that are already included in the Nasdaq 100, S&P 500, S&P Small Cap, and S&P MidCap regardless of their fundamentals. That is the keyword, that with no regard to the underlying business quality, the index funds will purchase the companies securities as long as it is included in the list. For example, if a million dollars invested in an index fund that tracks Nasdaq 100, the portfolio team will allocate the fund based on each individual weights of the stocks. If Apple market capitalization is 10.5% of the entire Nasdaq 100 index, then $10.5 million dollars will be invested into the Apple stock with no questions asked.
In short, as more and more investors move their cash into the passive investment, it is guaranteed that some portion will be allocated to the index funds. Hence, any stock that makes the cut to be included in the index will see their stock price rise faster than their earnings (expanding P/E) over time. Ever since the 2008 financial market crash, we have seen more and more capital move into passively managed investments and index funds along with it. It would be unjust if we completely deny the role that these index funds have played in these bull market.
Though it may seem that stock prices will only go up, index funds carry a dark side. Index funds will sell securities as fast as they purchased them. When investors sell their index fund shares, it is what we call redemption. Unless the index funds have cash sitting (along with futures but that’s for another time), the management will have to sell certain securities so that the investors can receive their cash. When the management sells securities, it is not selling in a proportion of each stock of an index, it is selling certain securities based on some criteria; loss harvesting, changes in member weights, etc. This could drive down those particular stock prices which could impact their weights in the index membership. If Apple market capitalization reduces to 9.8% from 10.5%, every index fund that follows Nasdaq 100 will have to sell Apple shares so that their correlation doesn’t take a hit. Hence, it is entirely possible that a stock could see its price drop if its weight in the index membership change rather than a drastic change in its business fundamentals. If enough redemptions take place, it is very possible that the above-mentioned scenario could play out on multiple stocks at the same time. This could start a drastic domino effect that could cripple the financial markets. If there is any major stock market decline, index funds will only add more fuel to it. And it is my conjecture that we have already seen an example of it in December 2018.
