• Skip to main content
  • Skip to secondary menu
  • Skip to primary sidebar
  • Skip to footer

Optimized Portfolio

Investing and Personal Finance

  • Start Here
  • Investing 101
    • Beginners Start Here – 10 Steps To Start Building Wealth
    • What Is the Stock Market? How It Works & How to Invest in It
    • How To Invest in an Index Fund – The Best Index Funds
    • Portfolio Asset Allocation by Age
    • How To Invest Your Emergency Fund
    • Portfolio Diversification – How To Diversify Your Portfolio
    • Dollar Cost Averaging vs. Lump Sum Investing (DCA vs. LSI)
    • How To Invest Your HSA (Health Savings Account)
    • Factor Investing and Factor ETFs – The Ultimate Guide
    • more…
  • Lazy Portfolios
    • All Weather Portfolio
    • Bogleheads 3 Fund Portfolio
    • HEDGEFUNDIE’s Excellent Adventure
    • Warren Buffett Portfolio
    • Golden Butterfly Portfolio
    • Paul Merriman Ultimate Buy and Hold Portfolio
    • Ben Felix Model Portfolio
    • Permanent Portfolio
    • David Swensen Portfolio
    • 60/40 Portfolio
    • more…
  • Funds
    • VOO vs. VTI – Vanguard S&P 500 or Total Stock Market ETF?
    • The 7 Best International ETFs
    • The 8 Best Small Cap ETFs (4 From Vanguard)
    • The 5 Best REIT ETFs
    • The 5 Best EV ETFs – Electric Vehicles ETFs
    • VIG vs. VYM – Comparing Vanguard’s 2 Popular Dividend ETF’s
    • The Best Vanguard Dividend Funds – 4 Popular ETFs
    • The 5 Best Tech ETFs
    • The 7 Best Small Cap Value ETFs
    • The 6 Best ETFs for Taxable Accounts
    • The 5 Best Emerging Markets ETFs (1 From Vanguard) for 2023
    • more…
  • Leverage
    • What Is a Leveraged ETF and How Do They Work?
    • How To Beat the Market Using Leverage and Index Investing
    • The 9 Best Leveraged ETFs
    • Hedgefundie’s Excellent Adventure
    • Leveraged All Weather Portfolio
    • Leveraged Permanent Portfolio
    • Leveraged Golden Butterfly Portfolio
    • NTSX – Review and Summary
    • TQQQ – Is It A Good Investment?
    • PSLDX – A Review
    • SWAN – A Review
    • RPAR Risk Parity ETF Review
    • more…
  • Dividends
    • The Best M1 Finance Dividend Pie
    • The 11 Best Dividend ETFs
    • The Best Vanguard Dividend Funds – 4 Popular ETFs
    • VIG vs. VYM – Comparing Vanguard’s 2 Popular Dividend ETF’s
    • 8 Reasons Why I’m Not a Dividend Income Investor
    • QYLD – A Harsh Review
    • more…
  • Brokers
    • The 5 Best Stock Brokers
    • The 4 Best Investing Apps
    • M1 Finance Review
    • Brokers with the Lowest Margin Rates
    • M1 Finance vs. Fidelity
    • M1 Finance vs. Vanguard
    • Webull vs. Robinhood
    • Stash vs. Robinhood
    • M1 Borrow Review (How M1’s Margin Loan Works)
    • more…
  • Retirement
    • The 10 Best ETFs for Retirement Portfolios in 2023
    • The 4% Rule for Retirement Withdrawal Rate – A Revisitation
    • Sequence of Return Risk in Retirement Explained
    • Traditional IRA Explained
    • Roth IRA Explained
    • 401k vs. Roth IRA
    • Roth IRA vs. Traditional IRA
    • Backdoor Roth IRA Explained
    • more…
  • My Toolbox

No, There’s Not an “Index Fund Bubble.” Here’s Why.

Last Updated: April 27, 2023 No Comments – 5 min. read

The term index fund bubble has been thrown around frighteningly often in recent years. In this post I'll explain why there's not one and why the primary fundamental argument itself doesn't make much logical sense.

Disclosure:  Some of the links on this page are referral links. At no additional cost to you, if you choose to make a purchase or sign up for a service after clicking through those links, I may receive a small commission. This allows me to continue producing high-quality, ad-free content on this site and pays for the occasional cup of coffee. I have first-hand experience with every product or service I recommend, and I recommend them because I genuinely believe they are useful, not because of the commission I get if you decide to purchase through my links. Read more here.

If you've arrived on this page, hopefully you already know that index funds are just investable products like ETFs or mutual funds that track some index, such as the famous S&P 500. “Indexing” refers to the strategy of buying and holding index funds.

The evidence overwhelmingly indicates that indexing beats active stock picking over the long term. This has been known for a while, but blogs and YouTube and social media have allowed the message to spread rapidly and widely among DIY retail investors, and index investing has grown massively in popularity over the past 20 years or so as a result. This has led some to erroneously conclude that there is an “index fund bubble” that could burst – or at least slowly deflate – and derail everyone's portfolios and the securities markets as a whole.

The late Jack Bogle is considered the father of index investing. He founded the shareholder-owned brokerage firm Vanguard which is probably the most popular name in the biz for low-cost index funds. Bogle constantly espoused the benefits of low fees, diversification, and “passive” investment management. Adherents to his sage advice are known as Bogleheads, and their foundational model portfolio is called the Bogleheads 3 Fund Portfolio. I've got a detailed post on it here.

VOO and VTI, a couple ETFs that are commonly used as components in the Bogleheads 3 Fund Portfolio for the U.S. stock market piece, have assets of over half a trillion dollars combined.

So it makes sense, then, right? The piling into index funds is creating a bubble that has to burst or at least deflate at some point, right? Well, no.

The pervasiveness of this myth is likely simply due to it being touted by famed trader Michael Burry who won big on a single bet during the 2008 Global Financial Crisis by shorting the housing market. Burry even put on his hyperbolic hat to claim that index funds are like CDO's (collateralized debt obligations) that were a major part of the 2008 crash. His quote in Bloomberg's article made waves. A generous explanation would be that he was just going for a clickbait-y headline. At worst, he's forgotten how markets and asset pricing work.

But remember right off the bat that taking information as truth just because of its source is authority bias. We want to assess the information itself.

The logic of Burry's primary argument – and of most of the “index investing is a bubble” arguments – goes something like this:

  1. Index funds have seen huge inflows in recent years.
  2. This causes stocks inside the index to become artificially inflated.
  3. That's a bubble that may deflate when outflows happen, and prices will “snap back” to where they're supposed to be.

According to this argument, using an example of the popular S&P 500 Index, the 500 largest profitable publicly traded companies in the U.S., the 501st company that was excluded (and all those that follow) gets less attention and is undervalued, and the 499th company's price is inflated simply because it got included in the index. More generally, large stocks become overpriced and small stocks become underpriced according to this theory.

This is an argument of inefficiency.

An analogy I've seen to illustrate this idea is that previously, active trading was a cruise ship and indexing was a small canoe being towed by it. The canoe does not affect the speed or course of the cruise ship at all but simply gets to relax and take the same course at the same speed. However, Burry and others maintain that index funds have now grown large enough to be a cruise ship themselves.

cruise ship canoe

But this argument suffers from a logical fallacy; it conflates assets and price discovery. Assets means the amount of dollars held in a fund. Price discovery just means buyers buying and sellers selling create an equilibrium that is the market price. In this context, using our analogy, the size of the ship is largely irrelevant to its course.

Trading sets prices. And index funds make up a whopping 5% of all trades.

index trading

In short, index investing doesn't affect price discovery. Don't confuse AUM with setting prices. The former can be huge without materially affecting the latter.

Put another way in terms of AUM itself, active and passive being close in size doesn't dismantle the functional integrity of markets. While we're on the subject, though, it's worth mentioning that “passive” doesn't exist anyway.

To hammer this point home yet another way, we don't really care about the amount of assets in index funds; we care about how much trading those index funds are doing. And it ain't much.

In the interest of full disclosure, the cruise ship analogy is also mathematically incorrect anyway; active traders still own the majority of shares of public companies at about 65%. In fairness, that balance may shift at some point in the not too distant future, but again that doesn't really mean anything.

Are mega-cap tech stocks at the top of the S&P 500 overvalued? Maybe. But it's not indexers who are causing the overvaluing. There are still enormous assets held and traded by active funds, hedge funds, day traders, and private managers. And stock prices still move on new information.

Our pals Fama and French submit that the rise of index funds is simply pushing bad managers out of the market, leaving skilled managers to set prices. Further, they maintain that it doesn't take much active trading to create an efficient market.

Other researchers have gone so far as to conclude that indexing makes short selling more efficient, thereby improving price discovery. Talk about a counterpoint.

But let's also circle back to the fundamental point about inefficiency. Burry suggests that because cap weighted indexes get all the attention, smaller, value-y-er stocks are undervalued and less efficient. Factor investors like myself already tilt small value for other reasons, but I'm hoping Burry doesn't cite the neglected firm effect if small value does indeed do well in the coming years. Something, something, narrative bias and hindsight bias.

This is itself another foundational fallacy upon which the bubble argument rests. Markets are not inefficient enough to allow for consistent exploitation. If Burry's proposed inefficiency did exist, skilled managers would simply arbitrage it away. In that sense, markets are self-correcting.

Let's also not forget that Burry and other private asset managers have a direct, tangible incentive to suggest that there's something wrong with indexing. And it's worth noting that his anti-index-fund fearmongering isn't really new. Here's a quote from the Director of Research at Chase from 1975:

A proliferation of index funds, though accounting for ever-increasing amounts of investment monies, would lead to an inefficient market. A stock’s price would become more a function of the monies flowing into index funds than a reflection of its investment merits. The efficient market hypothesis would be dead.

Here are some other quotes from high-profile hedge fund managers about index funds:

index fund quotes
Source: Eric Balchunas, Bloomberg

At the end of the day, though, if any of this bubble talk does sound plausible to you or has you feeling uneasy, the simple solution, as usual, is just maximizing diversification. Buy as many stocks as you can in the investable universe around the globe with a total market fund, and then buy other asset classes as well. Hopefully you do that already! Doing so means you now own the precise assets that Burry believes are inefficient and undervalued. Nonexistent problem solved.


This was a pretty brief, simplistic take on this topic. For ones much more comprehensive and eloquent than my own above, check out Ben Felix's YouTube video here and Ben Carlson's mic drop piece here.


Disclosures: I am long VOO in my own portfolio.

Disclaimer:  While I love diving into investing-related data and playing around with backtests, this is not financial advice, investing advice, or tax advice. The information on this website is for informational, educational, and entertainment purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. I always attempt to ensure the accuracy of information presented but that accuracy cannot be guaranteed. Do your own due diligence. All investing involves risk, including the risk of losing the money you invest. Past performance does not guarantee future results. Opinions are my own and do not represent those of other parties mentioned. Read my lengthier disclaimer here.

m1

Don't want to do all this investing stuff yourself or feel overwhelmed? Check out my flat-fee-only fiduciary friends over at Advisor.com.

77 percent of millenials report their finances are a source of anxiety

Related Posts

  • Dollar Cost Averaging vs. Lump Sum Investing (DCA vs. LSI)
  • Webull vs. Robinhood Brokerage Comparison (2023 Review)
  • The 3 Best Transportation ETFs To Watch in 2023
  • Sharpe Ratio vs. Sortino vs. Calmar – Risk Adjusted Return
  • Improving M1 Finance’s Moderately Conservative Portfolio Pie

About John Williamson, APMA®

Analytical data nerd, investing enthusiast, fintech consultant, Boglehead, and Oxford comma advocate. I'm not a big fan of social media, but you can find me on LinkedIn and Reddit.

Reader Interactions

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Primary Sidebar

  • Facebook
  • Instagram
  • Reddit
  • Twitter
  • YouTube
  • Patreon

Join 5,372 other investors

Take control of your financial future by subscribing to receive exclusive emails with expert tips, news, and notifications of new posts and important updates.

Don't worry, I hate spam too. No ads.

John Williamson, APMA®

Analytical data nerd, investing enthusiast, fintech consultant, Boglehead, and Oxford comma advocate. I'm not a big fan of social media, but you can find me on LinkedIn and Reddit. Read More…

Most Popular

Ray Dalio All Weather Portfolio Review, ETFs, & Leverage (2023)

HEDGEFUNDIE’s Excellent Adventure (UPRO/TMF) – A Summary

Golden Butterfly Portfolio Review and M1 Finance ETF Pie

David Swensen Portfolio (Yale Model) Review and ETFs To Use

53 Lazy Portfolios and Their ETF Pies for M1 Finance (2023)

VIG vs. VYM – Vanguard’s 2 Popular Dividend ETFs (Review)

Warren Buffett ETF Portfolio (90/10) Review and ETFs (2023)

Bogleheads 3 Fund Portfolio Review and Vanguard ETFs (2023)

Paul Merriman Ultimate Buy and Hold Portfolio Review, M1 Pie (2023)

The Best M1 Finance Dividend Pie for FIRE & Income Investors

m1 sidebar

rocket money

m1 sidebar

visor sidebar

retirable

Portfolio Asset Allocation by Age – Beginners To Retirees

The 7 Best Small Cap ETFs (3 From Vanguard) for 2023

9 Best International ETFs To Buy (6 From Vanguard) in 2023

The 3 Best Inverse ETFs to Short the S&P 500 Index in 2023

Ben Felix Model Portfolio (Rational Reminder, PWL) ETFs & Review

Factor Investing and Factor ETFs – The Ultimate Guide

NTSX ETF Review – WisdomTree U.S. Efficient Core ETF (90/60)

The Ginger Ale Portfolio (My Own Portfolio) and M1 ETF Pie

TQQQ – Is It A Good Investment for a Long Term Hold Strategy?

QYLD – Avoid This ETF as a Long-Term Investment (A Review)

The 5 Best T Bill ETFs (Treasury Bills) To Park Cash in 2023

JEPI ETF Review – JPMorgan Equity Premium Income ETF

SPAXX vs. FZFXX, FDIC, FCASH, FDRXX – Fidelity Core Position

Recent Posts

“Should I Own International Stocks?” Yes. Here’s Why.

Return Stacking Explained – Greater Returns With Lower Risk?

RSSB ETF Review – Return Stacked Global Stocks & Bonds ETF

Fees, Trees, & Forests – Stop Obsessing Over Expense Ratios

Optimized Portfolio “Best in Class” ETFs List for 2023

7 Best Covered Call ETFs for Income Investors in 2023

Roth IRA vs. Traditional IRA – Which Is Better for You? (2023)

How To Build a 3 Fund Portfolio at Fidelity in 2023

Fidelity ZERO Funds Review – What’s the Catch?

Jack Bogle Was Wrong About These 3 Things

I Bonds Explained (US Savings Bonds) – Ultimate Guide (2023)

Sharpe Ratio vs. Sortino vs. Calmar – Risk Adjusted Return

Portfolio Risk Explained – How To Think About Risk and Volatility

The 10 Best ETFs for Retirement Portfolios in 2023

VOO vs. VOOV vs. VOOG – Vanguard S&P 500, Value, or Growth?

View All...

Footer

  • Facebook
  • Instagram
  • Reddit
  • Twitter
  • YouTube
  • Patreon

Amazon Affiliate Disclosure

OptimizedPortfolio.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.

Email Newsletter

Sign up to receive email updates when a new post is published.

Don't worry, I hate spam too. No ads.

About - My Toolbox - Privacy - Terms - Contact


Copyright © 2023 OptimizedPortfolio.com

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Ok, Got ItReject Read More
Privacy & Cookies Policy

Privacy Overview

This website uses cookies to improve your experience while you navigate through the website. Out of these, the cookies that are categorized as necessary are stored on your browser as they are essential for the working of basic functionalities of the website. We also use third-party cookies that help us analyze and understand how you use this website. These cookies will be stored in your browser only with your consent. You also have the option to opt-out of these cookies. But opting out of some of these cookies may affect your browsing experience.
Necessary
Always Enabled
Necessary cookies are absolutely essential for the website to function properly. This category only includes cookies that ensures basic functionalities and security features of the website. These cookies do not store any personal information.
Non-necessary
Any cookies that may not be particularly necessary for the website to function and is used specifically to collect user personal data via analytics, ads, other embedded contents are termed as non-necessary cookies. It is mandatory to procure user consent prior to running these cookies on your website.
SAVE & ACCEPT