Indexing is all the rage these days. Investors are realizing that they are paying a lot of fees to fund companies to provide average rates of return (below average in some cases). They’ve done the math and see that they can do better by investing in cheap no load ETFs and similar products that track the index. Vanguard has been pushing this strategy for decades now and has really seen traction grow in this area over the last 15 years or so, along with the growth of ETFs (not a coincidence).
As this strategy gains more traction and becomes even more common, I start asking a lot of questions to myself. Will it have an effect on the markets? Will it cause mispricing? Could the stocks in an index respond differently simply because they are part of an index? Could this strategy inadvertently increase risk and volatility if it became too popular?
Could this be the start of an Index Bubble? Everyone flocked to real estate, then flocked to bonds. Are investors now moving to indexes?
The problem is not the tools used to construct the portfolio (ETFs in this case). In fact, ETFs and other low cost, passive investments offer unique advantages that allow investors to access markets in a way they never could before. There seems to be an ETF for just about everything out there.
I see the problem in using passive investments with a passive strategy, or in other words a “buy and hold” strategy using low cost Index ETFs with periodic rebalancing to a specific allocation. For example, you have a portfolio consisting of 5 specific ETFs that are rebalanced annually to a specific percentage.
Never before have investors had the opportunity to completely remove judgement from investment decisions and be completely passive. Just 10 years ago, many investors used active investments (mutual funds where the fund manager is selecting investments) with a passive strategy (buy and hold).
It’s too early to tell how this will unfold and how this could affect the individual investor.
This strategy will work for many investors, but it may be the popularity of the strategy that ultimately leads to its downfall.