The rationale for index investing is based on something called market efficiency, a concept for which Eugene Fama, its creator, was awarded a Nobel Prize last year.
The theory states the market is hard to beat because of the collective wisdom which results from millions of investors trading daily with one another in pursuit of returns, quickly incorporating all available information into security prices. In other words, it is a paradox; the market is efficient and hard to beat, in part, because so many investors try to beat it.
Recent growth in the popularity of index funds has caused some observers to ask, “Has indexing gotten too big?” They wonder whether more investors moving to index funds and giving up trying to beat the market makes it less efficient and, therefore, opens the door for active managers to succeed at stock picking and market timing.
It is important to recognize that while the number of index funds has grown in recent years, the vast majority of dollars remains invested in actively-managed strategies. At the end of 2013, roughly 35% of stock mutual funds were index funds, however, their total assets accounted for less than 15% of all dollars invested. For bond funds, 16% were index funds at year-end representing just 3% of all dollars invested. Stated differently, more than 85% of dollars in the stock market and 95% of the bond market remain invested in some form of active management.
One way to empirically evaluate whether indexing has gotten too big is to consider the cost of trading. If markets were becoming less efficient, we should expect to see bid-ask spreads (the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept) widen. In fact, we see the opposite. Since 2008, while more and more dollars have flowed into index funds, bid-ask spreads for stocks in the S&P 500 Index have declined.
Another objective measure to consider is the performance records of active investors. If the popularity of indexing had created a more favorable environment for stock pickers, we would expect to see a larger number of active investors beating the market. Over the past two years, however, the S&P 500 Index outperformed roughly 60% of all large cap stock funds. This measure of indexing’s advantage over active investing is larger, not smaller, than it was a decade ago (2005) when only 54% of active large cap funds beat the S&P 500 over the preceding two years.
We’re confident today’s markets are more efficient than ever. The rise of indexing, rather than disabling markets, has enabled more and more investors to fully earn the returns afforded by capitalism around the globe. Freed from the burden (and costs) of worrying about market prices, investors can turn their focus to what really matters—designing an appropriate investment strategy based on their personal objectives, values, time horizon and risk tolerance.
 Philips,Chris. “Has indexing gotten too big?” Vanguard research, June 17, 2014.
 S&P Indices Versus Active Funds (SPIVA®) U.S. Scorecard. Year-end 2013.