When everyone indexes, what is the market?

Today is the 50th anniversary of the launch of the Vanguard Group's pioneering S&P 500 index fund. The late Jack Bogle's creation - a low-cost fund that didn't try to pick individual stocks, but simply owned them all - was a brilliant innovation that liberated ordinary investors from the burden of high fees.

Over half a century, the Vanguard index fund VFIAX has turned $10,000 into $2.4 million, Vanguard says.

Nowadays, the value of "low-cost index funds" is a universal mantra on Wall Street. Even people who know very little about finance typically know that stock-picking funds rarely beat a low-cost fund that passively follows "the index," and that costs really matter a lot to your long-term returns.

As a simple illustration, if you make 10% a year (on average) on your stocks, over a 35-year investing horizon, you'd turn an initial $1,000 into about $28,000. But if you subtracted 1.5% a year for fund fees - which is what used to be normal - you'd end up with less than $17,500. That annual charge would have ended up costing you 40% of your total returns. That's what happens when even small-seeming numbers get compounded, year after year, over decades.

Investors everywhere owe Vanguard founder Bogle a huge debt. The index fund is a huge improvement over much of what it replaced; Vanguard estimates indexing has saved private investors $570 billion in fund management fees just since 2000. So long as investors also stick with it over the long term, instead of selling during a crash and buying again during the next boom, they've done well out of it.

But that's not the whole story. Enter the logical phenomenon known as the "fallacy of composition," which says that just because something makes sense for you (or me) to do, if too many people do it, or everyone does it, it can stop making sense.

Vanguard-inspired indexing now dominates the stock market. The Investment Company Institute, the trade association for the fund industry, says that index funds now account for 64% of all the money American investors have in the U.S. stock market.

And the influence goes further. Many or most of the "active" fund managers remaining - meaning the ones who still try to pick stocks - have become "index huggers," either quietly or openly. They may try to add value around the edges, but overall, their U.S. stock allocation will stick pretty closely to the index, particularly the S&P 500 SPX. Anything else is too risky - not for the clients, but for the manager, who is likely to get fired if his or her stock picks end up underperforming the index.

So, one way or another, indexing now dominates the U.S. market.

At some point, it raises the question of what actually is the market. If everyone is buying stocks based solely on their market value, how is that value actually being set?

When only a small number of investors are indexing, they are basically getting a free ride off the back of all the costly stock research and trading being done by everyone else. But once everyone is trying to get a free ride, who's left to provide it?

You need some active stock pickers to buy and sell a stock before you can claim, as index-fund supporters, that the current price perfectly reflects all known information about the stock. If no one is actively picking stocks and setting prices, it's like there's no one driving the bus.

We are not there yet. But maybe we are close.

One ominous sign is the ridiculous scale of stock-market "concentration." Index funds buy stocks in proportion to their current market value, meaning that they throw vastly more money into the stocks that are already expensive, and very little into those that are cheap and neglected. Right now, the top 10 companies in the S&P 500 by market value account for 40% of the entire index's value. In other words, if you buy an S&P 500 index fund expecting to get maximum diversification, you are actually committing 40% of your money to just 10 companies - and spreading the other 60% across the remaining 490.

This is, obviously, nuts.

It is also a direct refutation of the index-fund rationale. The reason stock picking supposedly doesn't work is because (in theory) current stock prices reflect all known information about each company, with the result that each stock offers the same risk-adjusted prospective returns. There are no free lunches.

Yet, if that is indeed the case, then why would you put more of your money in one stock - Nvidia (NVDA) - than you would put in the bottom 200 stocks in the index? It makes no sense. You are deliberately choosing to take on a lot of individual-stock risk for no good reason.

The explanation is that these traditional, "capitalization"- or "value"-based index stock funds are terrific for the fund industry because they can be scaled very easily. Adding new client money is no problem.

But for investors, an equal-weighted index fund logically makes more sense. That way, you spread your bets equally across 500 or even more stocks. There is quite a lot of research that such equal-weight strategies have done better over the long term than the traditional value-weighted index fund. (See here and here.)

According to research by Hendrik Bessembinder, professor of business and finance at Arizona State University's W.P. Carey School of Business, over the 55-year period from 1971 through 2025, an equal-weight strategy beat the traditional value-based index approach by an average of 1.3 percentage points a year, or 12.6% to 11.3%. As the proponents of index funds repeatedly argue, such differences really make a big difference over time.

There are a couple of low-cost equal-weight ETFs available to U.S. investors. The Invesco S&P 500 Equal Weight ETF RSP charges 0.2% a year in fees; the iShares MSCI USA Equal Weighted ETF EUSA charges 0.09%.

Meanwhile, if you are buying a traditional S&P 500 index fund, right now, 8% of your money is going into one stock: Nvidia. I offer no view on the company or the stock - but Bessembinder's research also shows that the highest-value stock in the market has usually ended up underperforming the rest of the index over time.

-Brett Arends