Are index funds risky?

Are index funds risky?

Index funds are one of the most efficient ways to invest, allowing ordinary investors to gain exposure to a large number of securities at very low cost. But passive investing has grown so rapidly in recent years that some now argue we may be heading for an "indexing bubble." Is that something investors should genuinely worry about?

In this video, Ben Johnson, Director of Passive Funds Research at Morningstar, explains why he thinks these fears are overblown. The growth of index funds and exchange-traded funds has indeed far outstripped that of traditional actively managed funds, which is why the concerns have arisen. But the more meaningful question, he argues, is who sets prices at the margin. Passive funds are, by definition, very low-activity, low-turnover vehicles that simply track an index. They account for only a tiny fraction of actual trading in securities markets, which is where price discovery genuinely takes place, and where well-informed active managers still do the real work of setting prices.

You'll learn how the balance between passive and active investing is shifting. Passive funds remain less popular than active ones, but that's changing fast, with the ratings agency Moody's having predicted that passive would overtake active in the US within a few years. Yet even at that point, Johnson believes there's still a long runway for passive investing to keep growing before it has any real effect on price discovery, capital formation or underlying securities prices.

The takeaway: the worries about index funds destabilising markets appear, in Johnson's view, to be significantly exaggerated, and often fanned by those whose territory is most threatened, namely high-cost, high-turnover active managers. For ordinary investors, index funds remain a highly efficient, low-cost way to invest, and there's ample room for passive investing to expand without cause for alarm.

Chapters / Key points

• Why index funds are such an efficient way to invest
• What the "indexing bubble" concern actually is
• Why passive funds have grown faster than active funds
• The real question: who sets prices at the margin
• Why passive funds do only a tiny fraction of actual trading
• Where genuine price discovery still takes place
• Predictions that passive could overtake active in the US
• Why there's still a long runway for passive growth
• Why fears about index funds are, in Johnson's view, overblown

Transcript

Are index funds risky?

Robin Powell: 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 a 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.

Ben Johnson: 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 set 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.

Robin Powell: Passive funds are still far less popular than active funds. But that's changing fast. The rating agency Moody's has predicted that, in the US, passive could overtake active by 2021, and will certainly do so by 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.

Ben Johnson: 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 the passive 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.

Robin Powell: That's all for now. Thank you to Ben Johnson, and to you, for watching. Until next time, goodbye.