I'm reading The Beginners Investing Book by Matthew Kratter and to quote him directly:
In the old days, very few people practiced indexing. That guaranteed that it would provide pretty good returns. These days, anywhere from 50-70% of the money in the stock market is tied to indexing. This almost certainly ensures that investment returns will not be as good in the future as they have been in the past.
My question is why is this?
Though Mr. Kratter does appear to have a financial incentive to suggest that index funds are likely to underperform going forward, he is also making a legitimate criticism of index investing.
The market depends on a certain number of investors analyzing companies in order to discover the "efficient" price (i.e. the price that fairly takes into account everything publicly known about the company). Index investors are free riding on that effort. The more money that goes into index funds, the more likely there will be inefficiencies in market prices that active traders could exploit to get better returns than the index fund.
Imagine, for example, that first thing this morning, every investor put 100% of their money into broad-based index funds and all active trading stopped. Apple today comprises ~7.35% of the S&P 500 index so someone buying the S&P 500 index would be putting 7.35% of that inflow into Apple regardless of the fundamentals of the company. If Apple announced tomorrow that every iPhone in the world was going to explode at the end of the month, its price would likely still rise because it is a large part of most broad-based indexes. There would be no active investors to force the price lower in response to this terrible news.
Though this is a legitimate theory, in practice, it appears that there are more than enough active investors in the market to ensure that prices remain reasonably efficient. If index investors are creating price distortions, you'd expect that managers of active mutual funds would be able to identify and exploit these inefficiencies and would beat the index. To date, there is little evidence that active mutual funds as a class are regularly beating their index. If the percentage of passive investors rise and there are several years in a row that, say, 60 or 70% of active funds beat their index after fees, one might reasonably conclude that the tipping point has been found.
Googling "Matthew Kratter", and the first result is a "Trader University", with text:
Hi there! My name is Matthew Kratter. I am the founder of Trader University, and the best-selling author of multiple books on trading and investing.
There you go; that's your answer. Mr Kratter clearly has an interest in persuading people that indexing doesn't work any more, with the implication that they should buy his books and sign up for his courses or whatever and learn how to be active traders, and so that's why he claims indexing won't work.
“Prediction,” goes an old Danish proverb, “is hazardous, especially about the future.”
This sentiment has been attributed to a number of people, among them, Niels Bohr, the Nobel laureate in Physics and father of the atomic model.
Predictions that rely on trends to continue indefinitely often run into comical results. For example, I was watching a presentation regarding cell phone sales at a time when these phones were the bricks seen in the original Wall Street movie. Exponential growth out indefinitely. I raised my hand and pointed out that growth of new technology has to be asymptotic to population growth. Any model that suggests say 50 billion phones will be sold each year to a population of 10 billion people makes no sense. You see my point.
On the internet, especially social media, anyone can say anything. This is true of books as well. Just because it's in writing doesn't make it true. A search on how much of investing is indexed results in about 16%. If the source isn't reputable enough, a dozen results were in a tight range around that number. (Ad hominem attack alert) When an author's conclusion is based on such an incorrect premise (50-70%?) I'm not likely to continue reading. As I get older, my own time is too valuable.
If I were writing my own article, I'd suggest 15-20% as a reasonable range. Considering that Jack Bogle devised the index fund in 1975, nearly 50 years ago, I'd say that we are quite far from a time when the phenomenon your author suggests is likely to happen. We still have 6,680 actively managed mutual funds along with all the investors who buy individual stocks.
One last thought - The 10-year average return for large cap stock funds (active management) ending 2012 was 14.96% vs the S&P 16.58%. After fees, I get 16.56%. More than a 1.5% difference. Justin gave an excellent answer to the hypothetical "what if everyone indexed?" but the fact is simple. We are not on a path where I'd concern myself with this.
As many others have pointed out, the auther has his own interest in promoting active management. He does this by being (probably deliberately) imprecise. While index funds certainly have the potential to impact price discovery, I am missing the important distinction between assets in index funds and trading volume. Prices are determined by trading and if trading stops because everyone is just buying up an index fund as in the example of Justin Cave's answer, this will certainly be an issue. Index funds are estimated to cause less than 5% of stock trading volume (source: Blackrock) which in turn means that more than 95% of trading volume is done by active investors. Any obvious mispricing is unlikely to persist if basically all the trading volume is still there.
Remember, it is not the 30 year period buy-and-hold investor that makes prices in a market. It is the short-term trader that actually makes a market by actually buying and selling.
The author may be referring the concept of the index fund premium. This is the idea that when a stock is added to an index, index funds go out and buy it, giving it a price bump that is not related to its fundamentals.
For additions to the S&P 500 and Russell 2000, we find that the price impact from announcement to effective day has averaged + 8.8% and + 4.7%, respectively, and −15.1% and −4.6% for deletions.
https://www.sciencedirect.com/science/article/abs/pii/S0927539810000745
This means that as you are paying a higher price for the same return, your return as a percentage of capital is lower. Furthermore, if stocks are moved on and off an index, an index fund will buy stocks at a artificially higher price, and then, when a stock is removed, sell it at the natural lower price, incurring losses.
The conclusion "This almost certainly ensures that investment returns will not be as good in the future as they have been in the past," however, is a bit overreaching. It's well within the realm of possibility that the stocks in the indices could experience growth that exceeds the index premium (the Efficient Market Hypothesis predicts that such an event would not be expected, but that doesn't mean that a random walk could not have that result).
If you invest in an index fund, most of your money gets invested in mediocre companies. Warren Buffett points out here that the best results are obtained by investing in a few strong companies. A diversified portfolio of stocks of a few dozen companies will usually already be suboptimal, let alone an investment in an index fund.
