Will the popularity of index funds cause a pricing bubble in the stocks that make up an index?
With regard to commodity futures, a paper released in January 2010 by Aulerich, Irwin, and Garcia, concluded that index funds have essentially no impact on commodity futures. Looking at stocks, a stock that gets included in a major index does increase in price. It increases its turnover by 27% and increases its price by between 2.7% and 5.5%, according to information cited by Kula in this paper, though it looks like the price increase tends to happen in the lead up to the stock being included. Interestingly, I have read an article but cannot now locate it, which states that there's a measurable, albeit fairly small, price bubble on stocks included in common indexes, on Monday mornings, Friday afternoons, and at the start and end of the month. That is, the times when mutual funds are most likely to rebalance their holdings. This almost certainly applies to a lesser extent to other stocks, too. My understanding is that the price difference was very small, however. Generally speaking, stocks which make part of well-known indexes will tend to be in higher demand than stocks which do not. It remains the case that almost all actively-managed mutual funds are unable to consistently beat the indexes, even with this taken into account.
The idea with passive investing in ETFs is to eliminate the all important firm specific risk. I agree with him that it surely creates a herd mentality and might over/understate the fundamental prices for individual stocks. If fund managers could consistently maintain alpha, lower their 2/20, and not shutdown when they can't reach their high water mark, then maybe investors might come back to them. As it stands now, the money goes where it can get the best return with only market risk to worry about. "Note that an index fund may not be able to precisely mirror the index it's tracking. If enough many people invest enough money into funds based on that index, there may not always be sufficient shares available of every stock included in the index for the fund to both accept additional investment and track the index precisely.  This is one of the places where the details of one index fund may differ from another even when they're following the same index. IDEALLY they ought to deliver the same returns, but in practical terms they're going to diverge a bit. (Personally, as long as I'm getting ""market rate of return"" or better on average across all my funds, at a risk I'm comfortable with, I honestly don't care enough to try to optimize it further. Pick a distribution based on some stochastic modelling tools, rebalance periodically to maintain that distribution, and otherwise ignore it. That's very much to the taste of someone like me who wants the savings to work for him rather than vice versa.)" To start with gold has value because it is scarce, durable, attractive and can be made into jewellery. But that does not explain its current value. In the current economic climate, it is difficult for many investors to get a positive return on conventional investments such as equities or bonds. I theorise that, in such conditions, investors decide to park their money in gold simply because there are few other good options. This in itself drives the price of gold up, making it a better investment and causing a speculative boom. As you will see here, here, and here the gold price is negatively correlated with stock market indices. By definition, actively managed funds will underperform passive index funds as a whole. Or more specifically: The aggregate performance of all actively managed portfolio of publicly-tradable assets will have equal performance to those of passively managed portfolios. Which taken with premise two: Actively managed funds will charge higher fees than passively managed funds Results in: In general, lower-fee investment vehicles (e.g. passive index investments) with broad enough diversification to the desired risk exposure will outperform higher-fee options But don't take my wonkish approach, from a more practical perspective consider: I hate to point to Wikipedia as an answer, but it does describe exactly what you are looking for... The S&P 500 is a free-float   capitalization-weighted index   published since 1957 of the prices of   500 large-cap common stocks actively   traded in the United States. The   stocks included in the S&P 500 are   those of large publicly held companies   that trade on either of the two   largest American stock market   exchanges; the New York Stock Exchange   and the NASDAQ. The components of the S&P 500 are   selected by committee... The committee   selects the companies in the S&P 500   so they are representative of the   industries in the United States   economy. In addition, companies that   do not trade publicly (such as those   that are privately or mutually held)   and stocks that do not have sufficient   liquidity are not in the index. The S&P is a capitalization weighted index.  If a stock price goes up, then it comprises more of the total index.  If a stock goes down, it comprises less, and if it goes down too much, the committee will likely replace it. So to answer your question, if one stock were to suddenly skyrocket, nothing would happen beyond the fact that the index was now worth more and that particular stock would now make up a larger percentage of the S&P 500 index. "Stocks are regarded as an inflation hedge because when your money is worth less, everything else is worth more. i.e. Stocks are more expensive (go up) simply because your money is worth less, but not because of better earnings across individual companies. So that general idea can effect sentiment, whereby if everyone believes it then more people buy stocks if they think there will be a lot of inflation. But it doesn't explain actual behavior (whether ""more"" people buy, hold or sell.) It's worth noting that individual companies and stocks also may be adversely affected by inflation, since their own assets or accounting may already be outside of the currency and/or they may already be engaging in their own hedging." Irrational exuberance leads to crashes but the fundamentals recover.  This is absolutely going to hurt some companies with already announced IPO's and will delay others from going public.  But nothing fundamental has changed - some speculators just got shot down. "Comparing index funds to long-term investments in individual companies? A counterintuitive study by Jeremy Siegel addressed a similar question: Would you be better off sticking with the original 500 stocks in the S&P 500, or like an index fund, changing your investments as the index is changed? The study: ""Long-Term Returns on the Original S&P 500 Companies"" Siegel found that the original 500 (including spinoffs, mergers, etc.) would do slightly better than a changing index. This is likely because the original 500 companies take on a value (rather than growth) aspect as the decades pass, and value stocks outperform growth stocks. Index funds' main strength may be in the behavior change they induce in some investors. To the extent that investors genuinely set-and-forget their index fund investments, they far outperform the average investor who mis-times the market. The average investor enters and leaves the market at the worst times, underperforming by a few percentage points each year on average. This buying-high and selling-low timing behavior damages long-term returns. Paying active management fees (e.g. 1% per year) makes returns worse. Returns compound on themselves, a great benefit to the investor. Fees also compound, to the benefit of someone other than the investor. Paying 1% annually to a financial advisor may further dent long-term returns. But Robert Shiller notes that advisors can dissuade investors from market timing. For clients who will always follow advice, the 1% advisory fee is worth it." In the short term the market is a popularity contest In the short run which in value investing time can extend even to many years, an equity is subject to the vicissitudes of the whims by every scale of panic and elation. This can be seen by examining the daily chart of any large cap equity in the US.  Even such large holdings can be affected by any set of fear and greed in the market and in the subset of traders trading the equity. Quantitatively, this statement means that equities experience high variance in the short rurn. in the long term [the stock market] is a weighing machine In the long run which in value investing time can extend to even multiple decades, an equity is more or less subject only to the variance of the underlying value. This can be seen by examining the annual chart of even the smallest cap equities over decades.  An equity over such time periods is almost exclusively affected by its changes in value. Quantitatively, this statement means that equities experience low variance in the long run. "Indexes are down during the summer time, and I don't think it has something to do with specific stocks. If you look at the index history you'll see that there's a price drop during the summer time. Google ""Sell in May and go away"". The BP was cheap at the time for a very particular reason. As another example of a similar speculation you can look at Citibank, which was less than $1 at its lowest, and within less than a year went to over $4 ( more than 400%). But, when it was less than $1 - it was very likely for C to go bankrupt, and it required a certain amount of willingness to loose to invest in it. Looking back, as with BP, it paid off well. But - that is looking back. So to address your question - there's no place where people tell you what will go up, because people who know (or think they know) will invest themselves, or buy lottery tickets. There's research, analysts, and ""frinds' suggestions"" which sometimes pay off (as in your example with BP), and sometimes don't. How much of it is noise - I personally don't think I can tell, until I can look back and say ""Damn, that dude was right about shorts on Google, it did go down 90% in 2012!""" "You cannot actually buy an index in the true sense of the word.  An index is created and maintained by a company like Standard and Poor's who licenses the use of the index to firms like Vanguard.  The S&P 500 is an example of an index.  The S&P 500 ""index includes 500 leading companies"", many finical companies sell products which track to this index.  The two most popular products which track to indexes are Mutual Funds (as called Index Funds and Index Mutual Funds) and Exchange Traded Funds (as called ETFs).  Each Index Mutual Fund or ETF has an index which it tracks against, meaning they hold securities which make up a sample of the index (some indexes like bond indexes are very hard to hold everything that makes them up). Looking at the Vanguard S&P 500 Index Mutual Fund (ticker VFINX) we see that it tracks against the S&P 500 index.  Looking at its holdings we see the 500-ish stocks that it holds along with a small amount of bonds and cash to handle cash flow for people buying and sell shares.  If we look at the Vanguard S&P 500 ETF (ticker VOO) we see that it also tracks against the S&P 500 index.  Looking at its holdings we see they are very similar to the similar Index Mutual Fund. Other companies like T. Rowe Price have similar offering.  Look at the T. Rowe Price Equity Index 500 Fund (ticker PREIX) its holdings in stocks are the same as the similar Vanguard fund and like the Vanguard fund it also holds a small amount of bonds and cash to handle cash flow. The only real difference between different products which track against the same index is in the expense ratio (fees for managing the fund) and in the small differences in the execution of the funds.  For the most part execution of the funds do not really matter to most people (it has a very small effect), what matters is the expense (the fees paid to own the fund).  If we just compare the expense ratio of the Vanguard and T. Rowe Price funds we see (as of 27 Feb 2016) Vanguard has an expense ratio of 0.17% for it Index Mutual Fund and 0.05% for its ETF, while T. Rowe Price has an expense ratio of 0.27%.  These are just the fees for the funds themselves, there are also account maintenance fees (which normally go down as the amount of money you have invested at a firm go up) and in the case of ETFs execution cost (cost to trade the shares along with the difference between the bid and ask on the shares). If you are just starting out I would say going with the Index Mutual Fund would easier and most likely would cost less over-all if you are buying a small amount of shares every month.  When choosing a company look at the expense ratio on the funds and the account maintenance fees (along with the account minimals).  Vanguard is well known for having low fees and they in fact were the first to offer Index Mutual Funds. For more info on the S&P 500 index see also this Investopedia entry on the S&P 500 index. Do not worry if this is all a bit confusing it is to most people (myself included) at first." This is Rob Bennett, the fellow who developed the Valuation-Informed Indexing strategy and the fellow who is discussed in the comment above. The facts stated in that comment are accurate -- I went to a zero stock allocation in the Summer of 1996 because of my belief in Robert Shiller's research showing that valuations affect long-term returns. The conclusion stated, that I have said that I do not myself follow the strategy, is of course silly. If I believe in it, why wouldn't I follow it? It's true that this is a long-term strategy. That's by design. I see that as a benefit, not a bad thing. It's certainly true that VII presumes that the Efficient Market Theory is invalid. If I thought that the market were efficient, I would endorse Buy-and-Hold. All of the conventional investing advice of recent decades follows logically from a belief in the Efficient Market Theory. The only problem I have with that advice is that Shiller's research discredits the Efficient Market Theory. There is no one stock allocation that everyone following a VII strategy should adopt any more than there is any one stock allocation that everyone following a Buy-and-Hold strategy should adopt. My personal circumstances have called for a zero stock allocation. But I generally recommend that the typical middle-class investor go with a 20 percent stock allocation even at times when stock prices are insanely high. You have to make adjustments for your personal financial circumstances. It is certainly fair to say that it is strange that stock prices have remained insanely high for so long. What people are missing is that we have never before had claims that Buy-and-Hold strategies are supported by academic research. Those claims caused the biggest bull market in history and it will take some time for the widespread belief in such claims to diminish. We are in the process of seeing that happen today.  The good news is that, once there is a consensus that Buy-and-Hold can never work, we will likely have the greatest period of economic growth in U.S. history. The power of academic research has been used to support Buy-and-Hold for decades now because of the widespread belief that the market is efficient. Turn that around and investors will possess a stronger belief in the need to practice long-term market timing than they have ever possessed before. In that sort of environment, both bull markets and bear markets become logical impossibilities. Emotional extremes in one direction beget emotional extremes in the other direction. The stock market has been more emotional in the past 16 years than it has ever been in any earlier time (this is evidenced by the wild P/E10 numbers that have applied for that entire time-period). Now that we are seeing the losses that follow from investing in highly emotional ways, we may see rational strategies becoming exceptionally popular for an exceptionally long period of time. I certainly hope so! The comment above that this will not work for individual stocks is correct. This works only for those investing in indexes. The academic research shows that there has never yet in 140 years of data been a time when Valuation-Informed Indexing has not provided far higher long-term returns at greatly diminished risk. But VII is not a strategy designed for stock pickers. There is no reason to believe that it would work for stock pickers. Thanks much for giving this new investing strategy some thought and consideration and for inviting comments that help investors to understand both points of view about it. Rob Now company A has been doing ok for couple of weeks, but then due to some factors in that company its stock has been tanking heavily and doesn't appear to have a chance to recover. In this kind of scenario, what does happen?  In this scenario, if that company is included in the index being tracked, you will continue holding until such time that the index is no longer including that company.   Index funds are passively managed because they simply hold the securities contained in the index and seek to keep the allocations of the fund in line with the proportions of the index being tracked.  In an actively managed fund the fund manager would try to hedge losses and make stock/security picks.  If the manager thought a particular company had bad news coming maybe they would offload some or all the position.  In an index fund, the fund follows the index on good days and bad and the managers job is to match the asset allocations of the index, not to pick stocks. Passive implies following an index. Your question seems to ask about a hypothetical fund that starts, say, as an S&P fund, but as the index is adjusted, the old stocks stay in the fund. Sounds simple enough, but over time, the fund's performance will diverge from the index. The slight potential gain from lack of cap gains will be offset by the fund being unable to market itself.  Keep in mind, the gains distributed each year are almost exclusively long term, taxed at a favorable rate. "Index funds do leech a ""free ride"" on the coattails of active traders.  Consider what would happen if literally everyone bought index funds.  For a company there would be no motivation to excel. Get listed; all the index funds are forced to buy your stock; now sit on your derriere playing Freecell, or otherwise scam/loot the company.  Go bankrupt. Rinse wash repeat.  This ""who cares who John Galt is"" philosophy would kill the economy dead.   Somebody has to actually buy stocks based on research, analysis and value.  Company managers need to actively fear, respect and court those people.  They don't need to be mutual-fund managers, but they do need to be somebody.  Maybe activist investors like Warren Buffett will suffice.  Maybe retirement fund or endowment managers like CalPERS or Harvard can do this.  Better be somebody!  I'm all for index funds... Just saying only a fraction of the market's capital can be in index funds before it starts into a tragedy of the commons."