Are index funds pyramid schemes?

[Lordosis]

Peds I appreciate you trying to keep us on task but
" There ain't no gettin' offa this train we on!"

[Lordosis]

Sorry cannot edit on mobile but I forgot to label my obscure quote. Bonus points for anyone who knows.

[Tangler]

I think you are barking up the wrong tree. Try the Bogleheads forum. Those folks hate index funds.

[runfast00]

Thanks. I think I’ll take my question to the Bogleheads.

And yes my personal portfolio is 80% equity all of it held in Vanguard index funds.

[Tangler]

runfast00 wrote:

Thanks. I think I’ll take my question to the Bogleheads.

And yes my personal portfolio is 80% equity all of it held in Vanguard index funds.

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I'll heat the tar

[jacoavlu]

To the original poster

How old are you and what is your investing horizon?

[Zaphod]

No, you're thinking about this wrong. Pyramid schemes are entirely different beasts. Ofc if the underlying economy tanks the index that tracks the economy will as well, that's not a problem though it shows it's working as intended.

The majority of the market are still in active funds and it doesnt matter even if we were all all indexing, there will always be discretionary traders, and you hardly need any data all to keep a market pretty efficient.

[nephron]

I think that the op was talking about this phenomenon:

https://www.nytimes.com/2015/10/11/business/mutfund/the-ease-of-index-funds-comes-with-risk.html

 

I think that it was briefly discussed in one of the WCI podcasts as well.  In theory, if 100% of the investors become index fund investors, the market will become overvalued because everybody is just buying the same group of stocks blindly without any concern for their actual valuation.   The "bubble" would burst once everybody realizes that everybody was doing this?   Or maybe when someone realized that the value of an individual stock was being heavily overvalued because the index funds were purchasing them and increasing their value via supply demand rather then any intrinsic value to the stock?  It goes back to the "efficient market" hypothesis, in that if everyone is just buying the same stock because they are part of some index, their value will no longer reflect an efficient market because an index is not not efficient.   I do wonder if there may be some tipping point in the distant future when some 80-90% of the market is in passive indices.   I think that the market does need active traders to sell and buy individual stocks.  I would imagine that it's going to be one of those things in the distant future that doesn't happen in our lifetimes and doesn't effect us, like "climate change" (just kidding).

[Jaqen Haghar MD]

Not a pyramid scheme, but I do sometimes wonder what (yet unforeseen) problem/crash will arise over time, as more and more people use an indexing strategy.

When people ask about the problems with passive investing through indexes, they get shut down pretty hard and responses get emotional quick.  (To me, not a great sign)

Most opponents against passive index investing have a vested interest in getting commissions from active investing, so info against it is often biased, and good info is scarce.

Still, when everyone piles into something, and fails to consider the downside risk, it can sometimes set up a future surprise disaster.

...But I still use mostly a passive investing strategy.

for now.

 

[Dont_know_mind]

Index funds are 45% invested funds currently, so still in the minority. 10 years ago index funds were 25% of the market. So at this rate, they might be 70% in 10 years time.

At 70%, there could be better returns from active investing. At say 80 or 90%, perhaps it would start to get inefficient and it might pay to lean the other way.

The interesting thing about markets and investments is that they're based on human behavior. Markets change so absolute rules are hard to find.

Perhaps the question is not whether they are a pyramid scheme (they are not), but whether they are getting so popular that it is likely to degrade future expected return from the strategy. My wild (and probably incorrect) guess is they are not popular enough to underperform expectations, but may be getting to that point in 10 years time.

[runfast00]

Exactly, better said than me.  If everyone is only indexing will it over value the stocks in the index.

 

That said, I'm in my late thirties and will still probably be in the market 20-25 years from now...hopefully it won't happen soon

[nephron]

Index funds are probably too young to fully understand what the full effects on the markets will be.  It's like when drug x comes out and seems fine, until hundreds of thousands have been taking it for years and they realize that it's actually causing harm (eg celebrex).   I was just re-reading that nytimes article and I wonder if this trend towards index funds means that individual index funds (ie S+P 500) will always outperform the total stock market index.  The article noted a 9% increase in stock value once a stock was added to the S+P which they attributed to the number of people purchasing the stock to be included in their index.   The total market index will also capture this increase, but obviously it will be magnified for people who own the S+P.

[Peds]

runfast00 wrote:

If everyone is only indexing will it over value the stocks in the index.

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yes but this is an impossible scenario.

[VagabondMD]

runfast00 wrote:

Exactly, better said than me.  If everyone is only indexing will it over value the stocks in the index.

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In theory, it could amplify the market highs and deepen the market lows. The good news, is that not only are we not even close to that situation, it will never happen.

[Zaphod]

nephron wrote:

I think that the op was talking about this phenomenon:

https://www.nytimes.com/2015/10/11/business/mutfund/the-ease-of-index-funds-comes-with-risk.html

 

I think that it was briefly discussed in one of the WCI podcasts as well.  In theory, if 100% of the investors become index fund investors, the market will become overvalued because everybody is just buying the same group of stocks blindly without any concern for their actual valuation.   The “bubble” would burst once everybody realizes that everybody was doing this?   Or maybe when someone realized that the value of an individual stock was being heavily overvalued because the index funds were purchasing them and increasing their value via supply demand rather then any intrinsic value to the stock?  It goes back to the “efficient market” hypothesis, in that if everyone is just buying the same stock because they are part of some index, their value will no longer reflect an efficient market because an index is not not efficient.   I do wonder if there may be some tipping point in the distant future when some 80-90% of the market is in passive indices.   I think that the market does need active traders to sell and buy individual stocks.  I would imagine that it’s going to be one of those things in the distant future that doesn’t happen in our lifetimes and doesn’t effect us, like “climate change” (just kidding).

Click to expand...

Usually the people pushing this kind of a narrative are active fund managers set to lose. In aggregate their is very little difference in market structure. If that scenario ever were to come about, it would create a huge arbitrage and people will take the other side.