We’ve discussed index funds previously here, but essentially an index fund is a collection of stocks, typically from a ‘market index’ that you can invest in without having to buy the stocks individually. Investing in Vanguards FTSE Global All Cap index fund for example let’s you invest in just over 7000 stocks, it wouldn’t be possible to invest in these individually for obvious reasons.

Investing in index funds lets you buy the market instead of trying to beat it and thanks to Jack Bogle this became a reality in the 1970s. Many people chose to invest in index funds as its much easier than trying to find companies that will outperform the market index and they often provide better returns than mutual funds as the fees are much lower.

Why do People Think Index Funds are Overvalued?

Index funds and price discovery is a theory put forward that states a stocks price might be bid up for the sole reason it’s in a popular market index as opposed to having good fundamentals in the underlying business which could result in a lot of errors in the market correctly pricing stocks. The stocks of concern are generally larger stocks as these often make up a larger portion of most index’s, on the flip side smaller stocks could be forgotten about and as a result be undervalued.

Michael Burry caused a stir when he was interviewed after saying he believes the price discovery hypothesis. Burry is of course famous for predicting the dot com bubble and the housing crisis of 2008 and has a lot of loyal followers as a result. Burry stated that passive investing has removed price discovery from the equity markets and as a result suggests that this will disrupt the markets ability to weed out the good companies from the bad.

Index funds have grown significantly in terms of assets under management and people often think this could be a reason why we’re headed towards an index fund bubble although these figures are often overblown. You might find articles suggesting that half of all funds are in index’s which can be quite disingenuous as this isn’t just taking into account index funds and ETFs. Index fund ownership has increased but the ownership is still relatively low in comparison to the entire market. According to Blackrock for every one dollar traded on index funds there is a further 22 dollars traded in mutual funds which essentially debunks the price discovery argument. Jack Bogle has also argued that price discovery wouldn’t be disrupted even if index funds reached 80-90% of all investments on the market as there will always be people looking for value on the stock market and a smaller percentage of active funds would still cause effective price discovery.

The market has seen all time highs in recent months and many refer to sky high Shiller PE ratio’s (price to earnings ratio based on average inflation adjusted earnings) or the Buffett Indicator (the ratio of the total stock market valuation to GDP). The Buffett Indicator currently suggests the market is ‘strongly’ overvalued. So what does all this mean for index funds? Well index funds track the underlying assets in the stock market, if the market itself is overvalued then the index fund will also be overvalued.

Time in the Market is Better Than Timing the Market

Buying and holding index funds has always worked and the truth of the matter is no one knows when, if or how the market will crash. You can find articles from 2013 right up until present day saying the market is overvalued and a crash could be imminent. If you pulled your money out in 2013 you’d still be waiting to see the market drop below 2013 highs. In fact, in the 2020 crash we only briefly seen lows similar to that of 2018. As Peter Lynch famously said, more money has been lost trying to time a market correction than lost in the corrections themselves.

Passively investing in index funds should be a long term investing strategy done over 10, 20 or 30 years and during this amount of time in the market, crashes and corrections will inevitably happen. One of Jack Bogles famous sayings was stay the course, and for good reason. The longer you keep your money in the market and don’t concern yourself with things outside your control like macro economics the more time your money will have to grow through compound interest. $1000 invested each month with an annual return of 8% over 30 years equals $1.5 million, close to $1.2 million of that is interest gained from capital appreciation and reinvested dividends.

Bottom Line

Index funds might be ‘overvalued’ according to traditional measures such as the Shiller Ratio or the Buffett Indicator because the whole stock market might be overvalued. One of the reasons many people suggest index funds are overvalued is because of its negative effect on price discovery although this may be overblown. Even if index funds or the entire market is overvalued for that matter no on knows if or when the market will crash so you’re better to continue to invest in the market in the long run.

The views expressed in this post are the authors and should not be construed as financial advice

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David is an Engineer and Finance Writer educated to masters degree level with sound knowledge in investing, the stock market and personal finance. We hope the information provided on this site can help you achieve your financial goals.

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