Article – Index Fund Bubble, How Long Before It Happens? – A US Market Example

SPY, VOO and IVV by State Street, Vanguard and BlackRock are probably the most well-known of a wave index funds that have taken over among investors as they look for easy exposure to the blue chip S&P 500. They each are exchange-traded funds (ETFs) that follow the S&P 500, a cultural measuring stick made up of companies with the largest market caps in America. Buying such index funds is a practice known as passive investing, an approach in which investors essentially try to keep up with the performance of the market instead of outperforming it. As latter has mostly stuck to steady returns averaging 10% on an annual basis in the form of S&P500, that is why passive investing (though not officially known as this term before) gained such a popularity over time.

But there are some worries starting to arise that passive investing could be fueling a bubble of epic proportions in the stock market. There are also plenty of experts who say that the gross backdrop resembles 2000 when the dot-com bubble burst. One issue is the concern that passive investing has reached a critical “inflection point,” leading to fears of an impending “passive bubble” which could spell disaster for investors’ portfolios.

Because passive investing requires consistently buying into index funds regardless of market or individual business performance. As a result, assets under management in passive investing have seen explosive growth — growing from 3.86% of the total market at the end of 2002 to an estimated 13.29% by year-end 2023. While the trend into passive investing has some constructive elements, it signals an increased acknowledgment that most investors are not able to beat the market over time. Meanwhile, even the professionals are having a difficult time trying to beat the S&P 500 (only 13% of active managed funds outperformed this index in past ten years).

This is not to say that passive investing does not have its benefits, as it can provide some advantages but also has the potential for market domination in a very small number of companies. These days, a single group of seven technology stocks — often referred to as the “Magnificent Seven” — jolts around strips one-third from or tacks two-thirds back onto it. These companies have made investors enthusiastic around the opportunity in artificial intelligence (AI), driving Nvidia and others to new all-time highs. Indeed, these seven firms collectively make up 32.75% of the S&P 500’s market capitalization despite only representing around 1.4% of the total companies in numbers. Such a high level of concentration has never before been seen and is worrying in terms of market crash.

One of the main goals passive investors have is to diversify and thus reduce risk in their portfolios. Though, the growing centralization of market power in just a few tech giants has limited diversification. Given their size, if these seven fussy companies were to see some kind of a serious tumble, the entire S&P 500 might feel it. A 50% crash in seven stock prices listed here could make the S&P 500 nosedive by a solid 16% or more.

The eventual catalyst for the passive investing bubble is likely to be both this concentration risk, along with the nature of passive investing itself. Investors who invest in the S&P 500 or other index, however, are not making choices about individual companies based on what will perform well and what won’t. They are buying shares on the overall index, not each individual company. This causes what is known as market distortion since the prices of company stocks are inflated just because they belong to fancy indexes.

Large companies as ever, best exhibit: with Microsoft seeing its largest shareholders become the major ETF providers like Vanguard and BlackRock and State Street. All of these ETF providers own large chunks of Microsoft not because the company is so hot but because it is just over 4% or whatever in market cap weight thanks to its inclusion in S&P 500. This shareholder behavior is not unique to just Microsoft, as many other S&P 500 companies have sizable passive ownership overhang which cloud takeout valuation estimates.

One of the effects on this change in ownership, is a phenomenon called price discovery removal. Price discovery is the method, by which market finds a suitable price of stock through demand and supply mechanism. But when a significant portion of the shares are held passively, this normal price discovery process is broken. Stocks are purchased based on their being components of an index, rather than the actual value or performance of the company itself which inflates stock prices that do not accurately show what a firm is really making.

Related The Impact of Passive Investing on Price Discovery The investment banks explain that increased capital going into passive vehicles pulls away from the detailed security-level analysis needed to have true price discovery. Rather, investors are steered instead to their favored simple models than into sectors or factors, even index funds as templates but offer no way of appraising specific stocks within those categories.

The rise of passive investing has meant that as indexation increases, shares in large companies are owned based not on the fundamental business prospects but simply because they are in an index. Over time, it can end up pushing stock prices too high and may lead to a bubble. With a bubble, the prices of assets inflate over and above their intrinsic valuation through wrong reasons that are tangentially related to the real business models. In the case of passive investing, being essentially a bubble in that there is so much money flowing into index funds annually as to drive up the prices of just about every company on earth and particularly those at very top end of market.

It certainly smells of 2000 when the dot-coms were everywhere. Companies that had the word “dot-com” in their name saw triple digit percentage of returns just because they existed, with almost no fundamental basis. There is an important and relevant parallel in the high-growth AI-focused companies of today. Fundamentally speaking, these companies might generally be strong in terms of revenue growth and business model; it’s very tough to pay for a stock price that is determined mainly by speculation / hype.

However, there are certain aspects of the scene right now that distinguish it from dot-com era. In July of 1999, countless issuance companies grew their stock prices by talking a big game about the internet (all with no revenue to match). Today, instead, the likes of Nvidia are raking in billions on AI. This is the basic level of performance that has helped underpin their stratospheric stock prices, even as those valuations remain elevated on more speculative expectations.

On the other hand though, behavior of passive investors themselves could be another mitigating factor to an passive investing bubble as well. By contrast, while those who speculate may sell them in droves during a decline —panicking— passive investors rather stay the course and instead keep buying their monthly share of index funds. This steady bid for shares can help put a floor under how much U.S. stocks could crash.

In conclusion, the realization of a passive investing bubble is up for debate but concern over market power becoming overly involved in few mega firms and price distortions given how such investments work seems reasonable. On the other hand, passive investors and strong operating business performance of tech giants may offer some downside protection in a severe market correction. Nevertheless, investors should be mindful of the risks and stay updated with this rapidly evolving market.

By-
Jibu Dharmapalan
SEBI Registered Research Analyst
Registration No. INH000014678
GSTIN: 32AHVPD3247L2Z3
Mobile: +91 9656125475
Email: [email protected]