ETFs will cause the next market crash! You heard it here first!

Actually… No. Not even close.

One of the biggest myths about passive investing is that ETFs and indexing will cause stock market bubbles. The thinking is simplistic: since index funds have to buy all companies in the stock market, they have to blindly buy stocks whose prices have gone up, right? This makes stock market bubbles worse, right?

Let’s take a look and walk through the logic together to burst this myth’s bubble.

The Economist recently published a really well written article that dispelled this common myth.

The myth is that index investors make bubbles worse, because indexes have to blindly buy the stocks that have gone up in value. This buying supposedly exacerbates the rise in price of these stocks, pushing them further up.

How Do Index Funds Work?

To dispel this myth, we need to understand how index funds work. Let’s look at an S&P500 index fund. In rough terms, this fund owns the 500 largest stocks in the US market. A fund like this owns each of these 500 stocks in their proportional size with respect to each other.

Let’s say at the beginning of the year, an S&P500 fund owns 100 shares of Apple, worth about $20,000 and 100 shares of GE, worth about $1,200. The value of Apple shares in the portfolio is about 17 times the value of the GE shares. In the next year, the price of Apple goes up by 10%, while the price of GE stays the same. At the end of the year, the 100 Apple shares are now worth about $22,000, while the 100 shares of GE are still worth $1,200. The Apple shares are now worth about 18 times the value of the GE shares.

Without having to buy any more shares of Apple, the value of the Apple shares in proportion to the other shares in the portfolio has increased. The rise in price of those shares increases the proportion of that stock in the index, without having to buy more.

Let me put another scenario to you. When an investor moves from an active manager to an index fund, presumably because the active manager didn’t beat the index, the investor is effectively selling a subset of stocks that have underperformed the market. As they purchase the index fund, they are buying a bit of every stock in the market. In other words, the investor would be shifting money towards better performing stocks. When you put it this way, it makes it sound like indexing would encourage the formation of bubbles.

Active Management and Market Bubbles

But think about what would happen if index funds didn’t exist. Instead of moving the funds to an index fund, the investor would choose another active manager, who had presumably beaten the market in the last few years. This means moving his or her money not to all the stocks in the market, but to a subset of outperforming stocks. This would encourage a bubble much more than the move to an index fund.

This comes from a fundamental understanding of what’s called the Arithmetic of Active Management. A concept developed by Nobel Prize winner William Sharpe in the 60’s.

Do you think indexing creates market bubbles? Let me know in the comments below.