If everyone Indexed would Index funds still work?

[SmallPotatoes]

Correct me if I'm wrong, but I recall reading that at least some people have to trade securities for index funds to valuate properly. Therefore, a total Index Investment World isn't possible.

[AdamA]

I guess if everyone bought the same fund on the same day, and held indefinitely, then the index fund would not gain or lose value...you'd probably still collect dividends, though.  Interesting question...

[Tortoise]

If the stock market were populated only by cap-weighted index fund investors, here are a few odd things I'm guessing would happen:

• The entire stock market would rise and fall with net inflows and outflows of capital from the index funds, but the cap-weightings of each stock would remain fixed relative to each other.
• The cap-weighting of each stock in the index would be a frozen snapshot of the market at the moment the very last active trader converted to indexing.
• Over time, the fixed nature of the stocks' relative cap-weighting would cause massive disparities between price and reality to emerge for almost every stock in the index.
• Most companies on the stock exchange would no longer have an incentive to pay out dividends since ceasing the payments would clearly have no effect on the stock price.
• There would be no more IPOs since there would be no one around to the buy the stock; the index funds would buy only stocks in their index, which would not include--nor would it ever include--IPOs offered after the index became frozen in time when the entire world converted to indexing.

The last few points are just a few things I thought of to illustrate the absurdity that would result in an indexing-only world. In such a world, any investor with half a brain would be able to notice at least a handful of the massive misvaluations in the market and make a huge profit by taking advantage of them. He would only be able to trade with the index funds, so the trader's gain would have to be the index funds' loss. In that bizarre and unrealistic world, the lone active trader would become fabulously wealthy and the index fund investors would foot the bill.

Good thing we don't--and never will--live in that world! Given that there will probably always be numerous professional speculators in our financial markets (armed with more powerful computational resources than we're likely to have even years from now) continuously looking for those $100 bills lying on the sidewalk, our choice will probably always be to either (a) compete with them and likely come out on the losing end after costs and taxes are factored in, or (b) ride along with the market in an index fund to minimize costs and taxes and thereby come out comfortably ahead over the long run.

[Lone Wolf]

I think that Tortoise really nailed it.  Such a world would present tremendous opportunities for arbitrage.  That would naturally pull people away from indexing as the arbitrage opportunities became more and more obvious.

In the real world, the markets are so efficient that identifying those kinds of opportunities usually requires a lot of expertise and study in order to be profitable.  Those without the expertise and time (me!) can get a "free ride" via indexing so long as they're not attempting to beat the market.

[KevinW]

Taking this one step further, passive and active management exist in an ecosystem that seeks an equilibrium state.  If we wind up with "too much" indexing then market inefficiencies will become more glaring, enticing investors to trade actively, eradicating the inefficiencies.  Likewise if there is "too much" trading and arbitrage opportunities are scarce, then the high expenses of active management become more difficult to justify and investors will shift back to indexing.

On top of that, I doubt indexing could ever take over completely due to human nature.  For one thing it's not really possible to get everyone in the world to reach consensus on any issue, including this one.  For another, people have a tendency to overestimate their abilities, meaning that a majority of people believe they are better than average, which is of course impossible.  So many people will choose active management even if it isn't in their rational interests.

[HB Reader]

I wouldn't worry about too many indexers.

That is sort of like asking what would happen if everyone became a doctor.  There isn't anything everyone can or will do.