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Are index funds risky? [video]

Index funds are a very efficient way to invest

    Index funds allow ordinary investors to gain exposure to a large number of securities at a very low cost

    So, is this something investors should be worried about? 

    Some argue we may be heading for an indexing bubble, however Ben Johnson, Director of Passive Funds Research at Morningstar, explains why this is nothing to worry about...

    RP: Hello there. Index funds are a very efficient way to invest. They allow ordinary investors to gain exposure to a large number of securities at very low cost. Passively managed funds have grown in popularity in recent years — so much so, in fact, that some argue we may be heading for an indexing bubble. So, is this something investors should be worried about? Ben Johnson, Director of Passive Funds Research at Morningstar, says not.

    BJ: If you look at the growth of passive investing, it’s clear why these concerns have been raised, because passive investing, index funds, exchange-traded funds have been growing at a pace that has far outstripped the growth of traditionally actively managed funds. Now that said these are by definition very low activity managed funds. So the real concern should be, who is doing price setting at the margin? Does it continue to be well informed, well equipped active managers, or is it just passive funds that are blindly buying securities that are setting out to track the index? These low activity, low turnover funds are actually doing a very tiny fraction of the actual trading in securities markets, which is where actual price discovery is taking place, where prices are being set.

    RP: Passive funds are still far less popular than active funds. But that’s changing fast. The ratings agency Moody’s has predicted that, in the US, passive could overtake active by 2021 — and will certainly do so 2024. But even then, Ben Johnson says there’ll be far more room for passive investing to grow without having to worry about any adverse effects on the markets.

    BJ: I would argue that passives can grow a fairly long way. They have a long runway from where they stand today before you might see any real, meaningful effect on price discovery, on capital formation, on the underlying securities prices. I think these fears, with respect to passives effect on the overall market, are quite overblown. I think they are being fanned by frankly those who are threatened by them, whose territory is being encroached upon, which is high cost, high turnover active managers.

    RP: That’s all for now. Thank you to Ben Johnson, and to you, for watching. Until next time, goodbye.

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