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Have Index Funds Become Too Popular?

Have Index Funds Become Too Popular?

One of the biggest market debates in recent weeks pertains to a question that has flummoxed investors for years: should I put all of my money in broad-based index funds or try to beat the market by investing actively in stocks? It seems that after the 2008 market crash index funds have won -- more than $3 trillion in assets are now invested in index funds, according to industry trade group Investment Company Institute. Major U.S. markets are ending 2013 in record territory; the Dow Jones Industrial Average is up 20% since Jan. 1 while the S&P 500 Index has gained 25% year-to-date.

Related: Americans Have Never Been So Wealthy: Really!?!

Investors with large holdings in index funds are most likely smiling these days but that has not always been the case; index funds that mimicked the S&P or Nasdaq clobbered investors in 2000 when the dot-com bubble burst and again in 2008 when the financial system collapsed.

Related: Dow 20,000: Coming Sooner Than Expected, Seth Masters Says

In the attached video Yahoo Finance’s Aaron Task, Henry Blodget and Mike Santoli tried to get to the bottom of the index fund versus stock question. They also brought up a good point: have index funds become too popular?
“Index funds are the way to go,” argues Blodget. A longtime believer in index funds, Blodget has been pounding The Daily Ticker set for years, telling viewers that the best way to grow their hard-earned cash is with indexing.
“The math is irrefutable…if you passively index, you will over time beat most active managers,” Santoli agrees. But that’s possible because these index funds offer broad exposure “at very low costs and with very low turnover. It’s not because there’s magic in the index,” he notes.
The problem with indexing, Santoli says, is that every asset class has been boiled down to an easy exchange-traded fund (ETF) for investors. Niche categories that were normally off limits to the majority of retail investors – such as high-yield junk bonds – have now gone mainstream.
Index funds may be outperforming the returns posted by active managers…for now.
“Ten years from today, active fund managers have a good shot at beating the indexes,” says Task. “The pendulum has swung way too far where everyone thinks all you have to do is index and you’re going to do better. When everyone is on the same side as the boat there is a reversion to the mean.”

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