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Is There an Index Fund Stock Bubble?

By Motley Fool Staff – Nov 6, 2018 at 11:33AM

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Passive investing has become so popular, some top investors worry that it's inflating the value of many stocks.

There must be something in the air: A lot of investors right now are looking more closely at their asset allocations and wondering whether they need to adjust their portfolios. Case in point, the Motley Fool Answers mailbag this month includes a question from a listener who has heard the assertion that Americans' urge to diversify their way to "average," match-the-market returns via index funds is creating a bubble in those funds' most popular holdings.

In this segment, hosts Alison Southwick and Robert Brokamp are joined by special guest Buck Hartzell, director of investor learning and operations at The Motley Fool. The trio address the listener's concerns and discuss the ways a retail investor might want to factor the hidden risks of index fund allocations into their own strategies.

A full transcript follows the video.

This video was recorded on Oct. 30, 2018.

Alison Southwick: The next question comes from Michael. "I've read some convincing arguments, recently [including on], that have suggested that the flood of investors' money going into passively managed funds has the potential to create an index bubble. This money is being unevenly distributed to the top-performing large-cap stocks," [oh, hey there, Apple]. "If those few companies were to falter, it would cause a cascading effect downstream to smaller companies. Do you see any truth in this assessment?"

Robert Brokamp: It's a really interesting question! When you say the term "index bubble," that has different meanings for different people. What people are arguing is that indexing has done so well and become so popular that it won't do as well in the future, and that in the future actively managed funds will have an easier time of it.

I'm not sure if I agree with that or not. The long-term history shows it's very tough to beat an index fund. That said, what I think is more important [and it's more related to the previous question] is the more your portfolio is allocated to like an S&P 500 index fund, the more you are concentrating your portfolio in a handful of stocks. And particularly at this time, right now [more than 20% of] the S&P 500 is in technology stocks. The No. 1 holding is Apple and No. 2 is Microsoft. Google is in the top 10. You have a pretty big concentration in one sector.

So I think it makes more sense just to look at your index funds as part of your whole portfolio rather than just getting away from index funds just because they're index funds. I know Buck has an opinion about this, too, because we sit next to each other and we talk about index funds all the time, partially because we're both on the 401(k) committee and the Total Stock Market Index Fund is the biggest holding in our 401(k).

Buck Hartzell: That's right and we used to have the S&P 500. We switched over to the Total Stock Market Index just because that does have exposure to smaller and midcap companies, so somebody who wants diverse exposure to the stock market should get all ranges. That's why we did that.

But I think it's a great question and I would say in addition to the indexing, there's something that we talk about quite a bit around here and that's "closet indexing." There are those professional money managers who are scared to deviate much from the performance in the index, so although they charge higher fees than what you get from an index fund, they tend to have a large overlap in the holdings of those index funds.

I think there's probably even more support for some of that momentum around those stocks, and one of the things that we get a little worried about around here sometimes is that there's largely a handful of stocks that are driving the performance of that index. And when you get too concentrated [this happened in the late 1990s], you had companies like GE and some of the large-cap [Home Depot was one of them and Lucent was a big driver]...

Brokamp: Cisco.

Hartzell: ... and Cisco was over a $500 billion company. When they make up a big proportion of this whole index, you get a little worried if something happens and they're all in that same sector. That gets back to your sector comment too, Bro. We worry not just about the index, but some of those people, and there's a lot of them because they've underperformed and finally they give in and go, "I can't underperform anymore, so I'm just going to add some of these stocks." There's a big follow-on, ripple effect from that indexing that's been going on.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Alison Southwick has no position in any of the stocks mentioned. Buck Hartzell owns shares of AAPL. Robert Brokamp, CFP owns shares of HD. The Motley Fool owns shares of and recommends GOOGL, GOOG, and AAPL. The Motley Fool has the following options: long January 2020 $150 calls on AAPL, short January 2020 $155 calls on AAPL, short February 2019 $185 calls on HD, and long January 2020 $110 calls on HD. The Motley Fool recommends HD. The Motley Fool has a disclosure policy.

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