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Are index funds still a good investment?

by Kaj_Sotala1 min read2nd Dec 202025 comments

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I don't really follow the investment scene, but from people who do, I had gotten the impression that index funds are generally the best bet for a lazy investor. So late last year I started regularly putting some money in them. Now some of my more finance-savvy friends are saying that index funds might be in a bubble, with so much money going into them that their stocks are likely to be overvalued.

This page seemed to have a reasonable overview of the debate; one of the counterarguments that sounded the most plausible to me was that active traders are still making the majority of trades, so if index funds were overvalued, the active traders should make a killing on that inefficiency. But I don't think I really understand this domain well enough to evaluate that, and at least one of my friends who's better informed than me seems to think that the bubble is an issue.

(Additional question: if index funds aren't a good investment anymore, what is?)

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6 Answers

I think the Michael Burry concerns are reasonable. That mostly means a few of the most popular index funds are overpriced. There are many funds to choose from, and funds that aren't imitating the most popular ones still look like reasonable investments.

See also Colby Davis for some hints about which types of funds look risky.

I like Colby's article. And in general I put significant weight on these kinds of arguments. However, I also put significant weight on the hypothesis that Industrial Revolution-level economic change and growth is coming sometime in the next few decades.

And it seems like the very companies that appear overvalued by the metrics Colby is looking at would be the most likely (existing) ones to capture a disproportionate share of the returns from AI.

If there's some way to square the two views that suggests something other than just buying the market (indexing), I'd be interested to hear it.

Something like half of the companies that look overvalued do not look like they'll benefit much from AI. They look more like they were chosen for safety against risks such as recessions and other near-term risks. I'm thinking of companies such as Apple, Chipotle, Home Depot, Lululemon, Mastercard, and Guidewire.

The "next few decades" is too long a time. Try evaluating what would have happened if you'd invested in companies in 2008 that looked like they would benefit from this decade's demand for electric vehicles, robocars, or solar. Or what would have happened if you had tried to act in 1986 on Drexler's forecast (in Engines of Creation) of a global hypertext system taking off within 10 years?

I'm guessing that if I'd tried those, I'd have guessed on Toyota or Honda for electric vehicles; for solar I actually made some money in Evergreen Solar in 2005-6, so I'm guessing it would have been my top choice (with a few others from this list?); I don't know what I would have found for robocars; and I would have bought Autodesk if I'd realized it owned Xanadu (I'm unsure when I was able to find out that Autodesk had acquired Xanadu).

How well would those have worked? Evergreen Solar became... (read more)

6ESRogs1yThis is a good point. Perhaps it's worth shorting (or underweighting) specifically these companies. Surely Tesla would have been on your list, either then or shortly thereafter (they IPO'd in 2010). And that would have been a good bet. (I thought about buying in at the IPO, but figured I didn't know anything the rest of the market didn't. Then when they finally came out with the Model S and it was winning "Car of the Year" awards, and the stock price barely moved, I couldn't take it anymore and bought in in Jan 2013. I'm glad I did.) Note that industrial revolution-level change is more significant than the transition to electric cars. Maybe it's not more significant than a transition to nanomachines? Unfortunately I wasn't old enough in 1986 to be able to say what the evidence looked like then, and how that compares to the evidence for pending transformative AI today. All I can say is that it looks to me like AI is coming. And I'd be quite surprised if none of Google, OpenAI, Microsoft, Facebook, Amazon, Tesla ends up being a major player. Maybe that means I should go long some of those stocks (besides Tesla, which I'm already quite long [https://www.lesswrong.com/posts/BdyRhPcQaxte8bc8y/esrogs-s-shortform?commentId=qQn7bFakQwJfPsvpv] ), and short the rest of the S&P 500.
4PeterMcCluskey1yIf we get transformative AI in 2028, then I agree. I have some Google shares for AI-related reasons. But if we don't get it until 2040, then I'd be mildly surprised if any of them will be close enough to the cutting edge to be major players.
4ESRogs1yHaven't done any rigorous analysis, but it's my impression that the field of tech giants has stabilized a bit in the last couple of decades. In that, once you become a tech giant now, you don't drop out anymore. (Compare Microsoft's trajectory post-Google to IBM's post-Microsoft.) I expect there to also be new tech giants by 2040. But I'd be surprised if all the current trillion dollar market cap companies are irrelevant by then. That's thinking about them as tech companies, specifically. Rather than evaluating their current AI plays. But I think the fact that the tech cos have so much engineering talent means they're not likely to just totally miss the AI trend.

80% of this game is showing up. (That's the Pareto principle, not an exact figure.) If you don't have a better plan for your money and have the means to ride out a portfolio drawdown for a year or three, then by all means, invest some of it in index funds. But you can do a lot better than that with a little more effort.

If you're concerned about a bubble, the correct move isn't to get out (or not get in), but to diversify and leverage down. If you're over-allocated when the bubble bursts, then you lose your shirt. Don't bet the farm. But if you always avoid bubbles, you miss all the gains when they inflate. And sometimes they can keep inflating for decades.

Many of the best investments have a returns distribution with a negative skew. They go up in price precisely because they're prone to crashing hard. That's the risk premium.

Investing is not about avoiding risk. It's about managing it. You want exposure to this skew risk so you can collect the premium for it. But you also have to be able to survive a drawdown. Kelly is the optimal balance, but it's hard to use it directly.

In practice, this means leveraging up for index funds most of the time, and adjusting the amount of leverage based on its risk. This can be hard to quantify, however, the most important factor for index funds is their volatility. (Volatility is certainly not the only kind of investment risk.) Unlike asset prices themselves, volatility is much more predictable.

I personally (at present) have a portfolio of mainly TQQQ, UGL, and TMF, plus cash (among a few other things that take more effort and knowledge to manage), which are 3x-leveraged Nasdaq-100, 2x gold, and 3x long-term treasury bond ETFs, respectively, which I can leverage back down (when necessary) by allocating more of the balance to cash. I frequently (at least monthly) adjust their weights based on their recent volatility to maintain fairly constant and equal volatility exposure to each. That means, for example, that my allocation in terms of dollars to TMF is about double that of my allocation to TQQQ, even though my allocation in terms of volatility exposure is about the same.

[Epistemic status: I am not a financial advisor. I don't know your financial situation. For informational purposes only. You are responsible for your own money. Invest with due diligence. Also, read my other posts about this stuff.]

3x funds track daily moves and thus underperform logterm. Better to use traditional leverage through Interactive Brokers.

4gilch1yMost of the 3x ETFs compound daily, it's true. And there are costs to this--more from the fees than the compounding itself. But that doesn't automatically make them a bad long-term investment (even though I've heard that said). 3x funds are much more accessible than other kinds of leverage. You don't need a margin account. You don't need options. You can even trade them in an IRA where you don't have to pay taxes. That more than makes up for it. Most brokers charge way too much to consider using margin loans long term. IB does happen to be more reasonable, but loans are still not for free. And to get the best rates, you need a big account. You can't even get to 2x leverage on a Reg-T portfolio using margin loans. (On components sure, but not the whole portfolio, or you'll get a margin call next dip.) For portfolio margin, you need at least $100,000 at most brokers, and preferably a lot more so you don't get downgraded and margin called at the worst time. It's great if you can afford it, but one should start investing long before saving up that much.

I'm 100% in unleveraged equity index funds. If I were to want to decrease how long I am I'd just hold some cash, right? If I wanted to go more long with leverage, would it make sense to preferentially do that in IRA accounts or in taxable?

2gilch1yRight, e.g. 50% cash and 50% index fund would be 0.5x leverage. But this isn't once-and-done. You have to keep the ratio balanced as the index price changes, or you're changing that leverage factor. Notice that you tend to buy low and sell high when maintaining balance this way: As the bubble inflates, you're gradually pulling cash out of it, and when it finally crashes, you don't lose what you've already pulled out. And then you have a lot of cash on hand during the crash to buy the index when it's on sale. Had you not been maintaining the balance, all the gains from the inflation would be lost at the crash. Rebalancing does have some transaction costs, so one shouldn't do it too often. I do it about once a month or whenever volatility is dangerously high, but you'd get similar performance doing it once per quarter and when vol is high. The timing doesn't have to be too exact. Some do it whenever the portfolio has deviated from the target ratio by a certain percentage. And the balance doesn't necessarily have to be in cash for you to get similar benefits. Some other mostly-uncorrelated asset can work. Cash is not exactly risk-free. The dollar's performance has some amount of volatility relative to other currencies, and inflation means that you lose real value over time when holding cash. My portfolio balances the TQQQ against the anticorrelated TMF, with the mostly uncorrelated UGL as a ballast, and yes, some cash as well. I'm less certain about this part. It really depends on your financial situation and goals. Probably preferentially IRA, because taxes add up a lot. There are limits to how much you can put into an IRA each year. If you're balancing a portfolio distributed among multiple accounts, and one is an IRA then it can seem to be more tax-efficient to keep a portion of the cash you're balancing against outside the IRA, but if you over-allocate and lose, then even if you have the money to make up for it, you can't just replace your losses by depositing m

tl;dr: YES. But it also depends what you mean by 'good investment'

First, we can look at the claim that passive investing is a 'bubble.' Among those calling "Bubble!", I see two separate groups making two slightly separate claims.

One group claims that incessant inflows of passive money are inflating prices of the largest stocks (AAPL, MSFT, GOOG etc.) which make up the largest part of cap-weighted indices such that they trade substantially away from an equilibrium fair value. 

I think these claims are quite dubious. Prices are set by the marginal trade, and although I know little of micro-structure/market-making, markets are likely quite robust even to large amounts of so-called 'uniformed flow'.  To claim that the presence of such flow--even if it may have grown quite substantially--is distorting prices of some of the most liquid and scrutinized securities in the world for years on-end, requires substantial evidence. For now I mostly see handwaving and pointing to all sorts of valuation metrics from this crowd, with relatively little to show for it beyond that. (Disclaimer: the meta-contrarian in me is also broadly skeptical of 'bubbles' as a general concept. I'm partial to ideas that posit that both the dot-com boom and housing boom of the late-90s/early 2000s were far from bubbles qua bubbles, but that's a separate discussion.)

The second type of claim is more along the lines of  'passive flow has disrupted normal market functioning, particularly at a microstructure-level'. Here the claims are certainly both more speculative and more abstract. Claims here often appeal to complex-systems ideas, namely that certain feedback mechanisms will either cause a spectacular financial blow-up one day (killing passive by fire), or will drive markets to a permanent new equilibrium in which the Market Is Strictly Passive (killing active by ice). I'm not willing to entirely discount these ideas; however, the idea that active managers will be there to exploit potential passive-driven inefficiencies and bring markets back toward an equilibrium seems to be the more plausible base-case against which these more speculative theories have the burden to demonstrate superiority.

Here is where I will take a speculative turn myself and appeal to a macro-explanation of the passive phenomenon. Indeed, as others have pointed out, the last 10 years have been exceptionally strong for big tech stocks. Being long FAAMNG bettered just about every other macro trade out there in any asset class (save perhaps for being leveraged-and-perma-long German Bunds). 

Coming out of the 2008 crisis, we had extremely high equity risk premiums, coupled with central banks not quite sure how to deal with the ZLB, and indeed there is compelling evidence that monetary policy perennially leaned too tight in many developed economies for most of the post-08 period. What results is a low inflation, low nominal growth, low interest rate environment, with broad corporate balance-sheet de-leveraging, which is particularly favorable for such near-monopolies like FAAMG, with their stable & moderately growing cash flows of extended duration.


Now in terms of maxing out favorable risk/reward per unit time spent deciding an allocation, it still looks quite difficult to top passive. But that doesn't always mean a passive allocation to large-cap equities, 60/40 stocks/bonds, etc. will always be there to deliver.

My own (very speculative and tentative) view is that the next 5-10 years will not be nearly as strong for real equity returns as the last 5-10. For example, we have an FOMC that is taking active steps to commit to a more expansionary objective, at least attempting to make-up for undershoots in their 2% symmetric inflation target. However, the (current) level of discretion the FOMC appears to be favoring in terms of their reaction function has already lead some macro-historians to draw parallels to the 'stop-go' era of policy in the 1970s, which was a poor environment for financial assets of almost all types.

Intermediate-term, I think it's likely that the post-COVID macro environment will be characterized by high, but relatively unstable expectations of nominal growth, which would reverse many of the macro-tailwinds that benefitted FAANMG so greatly this past decade. Of course, this is LW, so if there also appears to be mounting evidence that we're about to transition to a new AI-driven mode of economic growth, a lot of this playbook gets tossed out the window :)

markets are likely quite robust even to large amounts of so-called 'uniformed flow'


I don't agree and would be interested in evidence for this. Have a look at what happened in 1999-2000 and see if you still think this. Investors moved en masse into hot tech funds, many "index" funds. The fund managers were to a large degree helpless as they had to follow fund mandates. Fund managers who stood aside as the madness grew lost funds under management rapidly.

"Indexing" is not actually indexing if you don't own the whole market. That would include stocks, bonds a... (read more)

3mkov_blank1yGood point and indeed indexing played a prominent role in the late 90s tech boom; it was a broad market phenomenon, in contrast to the idea that it was a micro-speculative frenzy contained to things like zero-revenue IPOs. However, here I’ll expand on the meta-contrarian “bubble” point and offer that the dot com boom was not a case of markets gone haywire. I think we had a case for real technological prospects coupled with a market buying into the expectation that the Greenspan Fed was capable of providing nominal stability over the long-term. It perhaps serves as a positive case study as to why some economists bang the drum so strongly for nominal GDP-level targeting. With expectations of nominal stability, the hurdle to invest in high-risk, long time-horizon projects, is greatly reduced. This can effectively yoink away much of the equity risk premium and could justify the high valuations and low expected forward returns to equity that marked the 1999-2000 period. I’ll caveat by saying that this is currently just my working model of the late-90s, but it perhaps offers the deliciously contrarian view that managers just blindly dumping money into tech indices were actually not ‘uniformed flow’, even if they weren’t fully cognizant of the incentives they were responding to at the time

TL;DR; TL;DR TINA

TL;DR In my opinion, yes, still a good investment, if only because the alternative is not great

I think there's several things to tease out:

1/ What do we mean by "Index Funds"? Are we talking about the platonic global cap-weighted fund which owns the entire investible universe? Are we talking about country specific cap-weighted funds? Sector specific? Cap-weighted but only the biggest n (S&P500, etc)? Cap-weighted, but also only if they meet certain governance / financial standards?

I find it quite hard to find fault with the platonic ideal of an index fund (although I will attempt to talk latter a little about some issues with it). Unfortunately, it's pretty much impossible to create for any number of reasons.

There are definitely potential issues with individual indices.

a/ Index inclusion - it's clear that being added / removed from the index can have massive impact on a company's valuation. Recent examples include Tesla and [these guys front running index inclusion](https://www.sec.gov/news/press-release/2020-217)

b/ Governance - as more and more of stocks are owned by non-voting, passive owners it's easier for management to get away with shadier dealings

c/ Anti-competitiveness - [Matt Levine has written extensively about this idea](https://www.bloomberg.com/opinion/articles/2020-01-09/people-are-worried-about-index-funds) I don't take it too seriously, and I don't think it harms investors as much as the broader market

d/ Missing the "good" investments - if assets revalue when they join an index, you are definitely missing out if all you are doing is buying the index. (At which point the assets will already have revalued). I think there is a similar phenomenon here related to where stocks are listed. The same stock can trade at vastly different valuations based on the stock market which its listed on. (Not at the same time, I mean here re-listing can be a big catalyst for stock price growth).

2/ What if index funds are overvalued in general?

"if index funds were overvalued, the active traders should make a killing on that inefficiency"

I don't think this is quite right. If our platonic index funds are overvalued then the entire market is overvalued and there's not really anything you can do about that as an active trader. (Except perhaps bet that it's going to go down, and that's a very tough bet to make). If you think that individual index funds are overvalued, that's still a tough trade, since you have to wait for company cash flows to prove you right, and you might be waiting a long time / find yourself squeezed out by weight of money long before then.

3/ What are our alternatives?

Perhaps this is a lack of imagination on my part, but I see roughly 7 areas where you can "invest" your capital. (Separate from "using capital as collateral for running a trading strategy").
 

a/ Cash
b/ Equities
c/ Real Estate
d/ Bonds
e/ Commodities
f/ Precious metals 
g/ Cryptocurrencies

There's a case (I think best made by Mike Green) which suggests the world is divided into "Cash" and "Non-Cash" (which we can proxy with equities and bonds) and that the use of index funds is causing the amount of cash held in the world to decline which causes non-cash assets to revalue higher and higher (especially when valued in cash terms). I don't think this story is completely true (I don't think all buyers of index funds are entirely price insensitive) but I think it has enough merit which is worth thinking about.

My general view is from an asset allocation point of view there is very little to encourage bonds, commodities, precious metals and crypto. (Safe) bonds have negative real yields. Hoarding commodities seems to have little utility so why should it have positive returns. Gold / Precious metals / Crypto only seems to derive it's value from some sort of Keynesian beauty contest which I feel I have no edge in so I tend to steer clear. That said, I still think it's worthwhile holding some of all of them if only to benefit from their lack of correlation, store of value properties which enable you to rebalance.

So we're left with Equities and Real Estate. I'm going to dump real estate into equities on the grounds that you can hold real estate via REITs, but I think RE has properties much more similar to inflation linked bonds than companies.

The next question, now we've established our asset allocation, is "How do I own my equities?". Again (lack of imagination on my part) I see roughly two choices here: Own index funds. Buy individual stocks.

Owning index funds has a lot to recommend it - cheap, easy to do, getting information from the whole market etc

Buying individual stocks has a lot of problems - how do you find them? how do you value them? what makes you think you're better at it than the market at large?  

My general advice to people who can't solve those problems is "Own Index Funds".

Some other things which I didn't mention here, but really are somewhat important stories

1/ Active trading (as opposed to active investing). Market making, stat arb, etc

2/ The rise of private investments. There's a decent case that the best listed companies get taken private, leaving the public markets with only the very largest companies which no-one can take private, and the companies which no private equity firms want to take public

3/ Semi-active investing / factor investing. I find it quite hard to ignore the evidence that there are factors which outper... (read more)

Passive investors own the same proportion of each stock (to a first approximation).  Therefore the remaining stocks, which are held by active investors, also consist of the same proportion of every stock. So if stocks go down then this will reduce the value of the stocks held by the average active investor by the same amount as those of passive investors.

If you think stocks will go down across the market then the only way to avoid your investments going down is to not own stocks.

The academic research (e.g. Santa Fe institute work referenced in Jarrod Wilcox's "Investing by the Numbers", an excellent book for LessWrong-ish people), suggests that while truly passive indexers do not cause problems directly, they can cause problems in other ways. 

They tend to amplify the effects of momentum players and price insensitive growth-oriented traders for example. In sufficient numbers they can therefore indirectly destabilize the market.

When they are not really indexers but picking sectors to "index" in, they certainly can add to the chaos.

Throughout the last decade (or last 15 years, really), FAANG stocks (and QQQ) have consistently overperformed the market/index funds, with roughly comparable maximum drawdowns relative to even the S&P. It was clear to many of us technophilic early adopters even in the late 2000s that Amazon/Google were going to take over the world (though I'd replace Netflix with NVIDIA as NVIDIA is just more innovative), and their returns have massively outperformed the market, with much smaller drawdowns. COVID only accelerated the returns from FAANG - however - with their monopolization (and penetration into all markets, reducing what upside risk there is left), I'm not sure if FAANG has as much market capture, going forward, as there was 5-10 years ago. I know some have said that it is safe to invest in "singularity stocks" like the cloud - ones that have non-zero chance of precipitating the singularity (or feeding into the data-heavy thesis that accelerationism happens when you have more data/compute power/better algorithms, and only tech-heavy companies have really embraced this trend - some even liken Tesla's valuation to one that you can only understand if it were a "tech stock"). 

This year has pretty much accelerated the growth of all "new technology" stocks too (eg everything and anything to do with "new tech" exploded in value => to be fair ALL the "meme stocks" performed well), but many are now  that they're overvalued and the upside risk to them is not as high as they used to be. Ark Invest is the closest thing there is to a "hedge fund" that tries to understand "new technology" (even traditional hedge fund people like Bill Ackman and Ray Dalio aren't technophiles or well-versed in "technology" => it's known that hedge fund people tend not to outperform the market on long timescales, but a surprisingly small percent of them are like, technophilic), and it has had amazing market-beating returns over the last few years (where you don't have to spend that much time paying attention to it). Also, despite technophilia, the ARKK funds haven't really beat index funds pre-COVID (similarly to solar ETFs, which somehow exploded post-COVID for who-knows-what reason)

You have to look at companies with managers who constantly keep up with new technology/trends (rather than dig into what has always worked for them) and who can be expected to never stagnate.

I'm a little concerned about post-COVID overvaluations across the "tech sector" (especially given the "stagnation hypothesis" that many, particularly the Thielosphere, is concerned about), but I would still put some into QQQ, as QQQ has vastly outperformed index funds (but QQQ may be in a bubble itself). John Hussman has sounded the alarm for years, but if you were paying attention to him, you would have lost out on the returns over the last 5 years. I've observed that most of the high-profile companies that have recently IPO'd (especially in the tech sector) and which have rapidly-growing userbases have had much higher returns than most other companies - just look at how far up Twilio and Slack and Spotify and Cloudflare have gone up. Many recent biotech companies that have targeted CRISPR have also gone way up but they're more at risk of a sudden catastrophic drop if a clinical trial doesn't pan out.

Many I know are bullish in cryptocurrency [particularly BTC\ethereum] again, esp given the prevalence of money printing/devaluation as a response to the COVID crisis (and perhaps as an easier/more politically feasible way to "get money into the economy" than is higher taxation ), and since BTC is near ATH and still nowhere at risk of being at a bubble.

A heuristic I might use: What products/technologies are the smartest/most innovative people (eg those at DeepMind) using? [eg note how viciously smart people in AI have massive salaries and actually, like, use their salaries on smg] Their resourcefulness + financial resources will only improve with time, and them having higher ability to have frictionless workflows (minimizing the amount of time they spend on unnecessary logistical things such as upgrading their PC/changing homes/buying a new car/backing up data/preventative medicine/etc)+ collect data + store energy for data centers + make use of these massive datasets depends on them having access to certain resources (be it energy, speed, technology, SSDs, advanced materials). Think of what they will be like 10 years in the future, and of the materials they will use to maximize their ability to make money-time (or money-time-energy) tradeoffs. Sufficiently resourceful companies will never saturate - they will figure out how to create demand in areas where previous demand was not thought of as existing (kind of like how if you create enough products and advertise them to people, you may convince them that they have a "need" they might not have thought out themselves). If you use this valuation in itself, you wouldn't be surprised at the massive increases in NVIDIA/AMD/GOOGLE/LRCX/GLW/cloud stocks/whatever..

[given current tech valuations, I feel that materials science is the sector that has the most potential to improve/advance, and I am somewhat invested in LRCX/MU/AMAT, but I feel like there still isn't, like, an equivalent to "big tech" for the materials science sector - there isn't a huge market [yet] for photonic or neuromorphic computing, for instance. This is overdue, and it's possible that "AI" can catalyze a massive shift in materials science innovation that could lead to fast AI takeoff]. Also, with quantitative easing and other novel financial instruments (such as potentially cryptocurrency fintech), we may be able to more quickly "manufacture ourselves" out of recessions/crises than before, without being overly dependent on politics or which party wins the white house and dictates tax policy => this flexibility is also why a great depression a la 1929 is unlikely to happen ever again). 

Throughout the last decade (or last 15 years, really), FAANG stocks (and QQQ) have consistently overperformed the market/index funds
 

True but you conveniently cut off the dot com crash, in which the NASDAQ QQQ crashed from 107 to 23 (79%) while the S&P500 only fell about 43%. In finance beware the selective "well chosen" example. 

From the 2000 top that is a return of only about 5% per annum compound. 

1Alex K. Chen1yThe dot-com crash was also preceded by an extremely obvious and unique bubble that has not been seen since - diversifying/rebalancing during a massive/obvious bubble doesn't take that much special skill or awareness, and we're more aware of bubble dynamics now than 2000.

catalyze a massive shift in materials science innovation that could lead to fast AI takeoff

Have you considered not investing in those things, for that reason? As I understand it, accelerating AGI timelines would be the dumbest thing I could ever do. (Money isn't worth winning if it comes at the expense of imperiling my species (and can't then be used to proportionately de-emperil them))

(My understanding is that alignment work likely requires serial contributions from slow human theorists, can't really be accelerated very much with availability of better ha... (read more)

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While alone this by no means makes index funds a bad investment the average life expectancy of an S&P company has shortened dramatically (the exact figures are easily google-able) which possibly presents a new type of risk they have never before faced.

If you think this isn’t temporary and maybe will continue I think it stands to reason that in the case of broad market indexes like the S&P the decisions of individuals involved in curating the index will become more influential. Which is somewhat antithetical to one of the hallmarks of an index fund; eliminating the need to pick well.

I'm not too sure about this thought but am wondering.

Derivative funds (by which I mean things like a mutual fund tracking index X or the SPY that tracks the SP500) are said to have more invested that the underlying asset (e.g. SP500 versus all the SP500 tracking funds). This doesn't fully make sense to me as all those derivative products just end up investing (largely) in the underlying index basket.

Sans the funds, all that money would be going into the assets underlying the index, right? If so it's not clear that the funds via the direct investment in the non-derivative world would be much different or even more "correct" that what the collection of funds produces.

However, in a sense the funds all substitute for quantity in the market. Their prices will be anchored off the underlying index but when the fund is bought an sold it is often between two sides buy/sell the fund shares and no change in the funds holdings occurs -- so no marginal trading in the underlying index assets occurs due to those trades. I suspect that would hold when you look at fund A having $1,000,000 sold and some other fund(s) getting $1,000,000 bought. Effectively even if these funds change their holdings the net out in the market of the actual index assets.

Can this actually lead to a more stable, better priced over all market or am I missing something?

Note, I get that some of the highly leveraged funds will possible produce somewhat different outcomes, as will general net outflows/inflows of total investment in the derivative funds just as direct flows for the equities underlying the particular index.