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Dec. 10, 2018, 4:50 p.m. EST

Your love of index funds is terrible for our economy

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By Michael Brush, MarketWatch

David Dee Delgado/Getty Images
Index funds pose a risk to the U.S. economy and even to capitalism itself, Michael Brush says.

Vanguard’s John Bogle didn’t know it at the time, but when he created the first index fund in 1975 he unleashed a monster.

Stock index funds have grown so popular that they now command $4.6 trillion in assets. That might seem like a good thing. After all, index funds have “democratized” investing and simplified the process for the average person.

But the truth is that index funds have gotten so big that they now pose a major risk to our economy — and even to capitalism itself. Here are three reasons why.

Index funds contribute to market melt-ups and meltdowns

The popularity of indexing has increased the risk of irrational bull runs and sharp declines.

On the upside, there are fewer active managers to “sell at the top” and keep runaway bull markets from getting irrational. That sets up markets for eventual big selloffs.

Here’s the other risk to the downside. With so much money in index funds (Bogle puts it at 17% of U.S. stock-market value), active managers now have far less cash on hand to buy stocks during sharp declines. This has blunted a natural shock absorber in the market.

A big part of the problem is that big index funds like the ones representing the S&P 500 /zigman2/quotes/210599714/realtime SPX -1.72% and the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA -1.62% are bunched up in the same names. So once selling gets going, individual investors panic and ramp up selling, pushing the same stocks down even more. “Selling begets selling and that’s when you get a run on the market for 800 points in a day,” says Neil Hennessy, chief investment officer at Hennessy Funds, referring to one particularly gut wrenching intraday move in the Dow in December.

This kind of volatility makes it harder for companies to raise capital, which hurts economic growth. I’m sure Lyft is not happy it has to raise capital in this market — because it is going to bring in much less.

Index funds reduce the quality of stock analysis

Harvard Law School professor John Coates likes to say that index funds create “social benefits” in the form of lower expenses. That’s true, but it is only captures a piece of the picture.

Because even when active managers underperform as they charge higher fees than index funds, they are still adding lots of value in our economic system. By deploying legions of brainy analysts to drill down on companies, active managers help ensure that stocks are priced correctly.

This is key in our system of capitalism because it assures that investment money flows to the companies that will make the best use of it. In other words, when securities are priced “correctly,” money raised via stock issuance is more likely to go to innovative and efficient companies like Amazon.com /zigman2/quotes/210331248/composite AMZN -3.01%  and less likely to go to sham managements. The trained professionals working for active managers identify the Amazons of the world and drive their stocks higher. Likewise, they root out the sham managers and drive their stocks down so low it makes it tough for the scammers to raise capital.

This matters because while the stock market is many things to many people — from retirement planning tool to day-trading playpen — at its core the market’s purpose is to allocate capital to the best companies.

Of course, we know that active managers and their armies of analysts don’t always get it right. But without their work, securities are much more likely to be mispriced. That’s because active managers are better at valuation analysis than the mom and pop investors in index funds. By definition, these passive investors have collectively thrown up their hands and said they can’t or don’t want to do securities analysis.

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