Over the last several years, index funds have received increased attention from investors and the financial media. Some have even made claims that the increased usage of index funds may be distorting market prices. For many, this argument hinges on the premise that indexing reduces the efficacy of price discovery. If index funds are becoming increasingly popular and investors are “blindly” buying an index’s underlying holdings, sufficient price discovery may not be happening in the market. But should the rise of index funds be a cause of concern for investors? Using data and reasoning, we can examine this assertion and help investors understand that markets continue to work, and investors can still rely on market prices despite the increased prevalence of indexing.

Many Buyers And Sellers

While the popularity of indexing has been increasing over time, index fund investors still make up a relatively small percentage of overall investors. For example, data from the Investment Company Institute shows that as of December 2017, 35% of total net assets in U.S. mutual funds and ETFs were held by index funds, compared to 15% in December of 2007. Nevertheless, the majority of total fund assets (65%) were still managed by active mutual funds in 2017. As a percentage of total market value, index-based mutual funds and ETFs also remain relatively small. As shown in Exhibit 1, domestic index mutual funds and ETFs comprised only 13% of total U.S. stock market capitalization in 2017.

In this context, it should also be noted that many investors use nominally passive vehicles, such as ETFs, to engage in traditionally active trading. For example, while both a value index ETF and growth index ETF may be classified as index investments, investors may actively trade between these funds based on short-term expectations, needs, circumstances, or for other reasons. In fact, several index ETFs regularly rank among the most actively traded securities in the market.

Beyond mutual funds, there are many other participants in financial markets, including individual security buyers and sellers, such as actively managed pension funds, hedge funds and insurance companies, just to name a few. Security prices reflect the viewpoints of all these investors, not just the population of mutual funds.

As Professors Eugene Fama and Kenneth French point out in their blog post titled Q&A: What If Everybody Indexed?, the impact of an increase in indexed assets also depends to some extent on which market participants switch to indexing:

“If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.”

What's The Volume?

Trade volume data are another place to look for evidence of well-functioning markets. Exhibit 2 shows that despite the increased prevalence of index funds, annual equity market trading volumes have remained at similar levels over the past 10 years. This indicates that markets continue to facilitate price discovery at a large scale.

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