The history of index-fund criticisms runs like this:
1) They Are Silly Investments
By definition a portfolio that matches the overall market before expenses will trail that market after its expenses are paid. Who would buy a fund that is guaranteed to be below average?
The logical flaw, of course, is that the average active fund will also match the overall market before expenses, will also trail after expenses are paid, and will trail by more than did the index fund, as the active fund's expenses are higher. Thus, in practice, "below average" translates to "above average." But you already know that; this claim has become obsolete.
2) They Distort Market Prices
Indexes draw arbitrary lines. This security goes into the index, while the next one does not. Such decisions boost the prices of index holdings while depressing those of securities that were left behind.
Perhaps, but the effects have at best been modest. For one, the major index funds are highly inclusive. The industry's leader, Vanguard Total Stock Market Index (VITSX, listed in the U.S.), currently holds 3,587 positions. No doubt the 3,588th-largest stock is hampered by not receiving any of that fund's assets, but that firm is a very low rung on the public-equity ladder.
In addition, there are always counterbalancing forces. For example, should indexers inflate taxable-bond prices, because taxable-bond index funds have many more assets than do their municipal-bond siblings, then individual investors are likely to notice the opportunity. They will favor munis until the yield differential narrows.
This argument took a severe beating when hedge fund manager Bill Ackman noisily complained that his largest holding, Valeant Pharmaceuticals, was mispriced because it had been neglected by the indexers. He was right that it was mispriced, but wrong about the direction. The company's stock price collapsed shortly thereafter, due to allegations of pricing fixing and accounting irregularities.
3) They Drive Market Prices
With index funds, the tail wags the dog. Because index funds buy without discrimination, they neither reward success nor penalize failure. Their cash flows, not economic fundamentals, determine the market's direction.
This related complaint could be germane. For example, Vanguard Total Stock Market Index is more than 3 times the size of Finland's bourse. If the Vanguard fund, or any competitor remotely close to its size, were to invest solely in Finland, it would swamp that marketplace.
This issue, however, remains solely theoretical. Almost all U.S. index-fund assets are in invested in three huge, broadly diversified areas: 1) large-company (or nearly all) U.S. equities; 2) investment-grade bonds; and 3) global equities. No fund accounts for as much as 3% of those marketplaces. The smaller, more-vulnerable investment sectors that could be rocked by index funds have attracted relatively few assets.
4) They Are Inattentive Stewards
Index-fund managers cannot provide effective corporate oversight, because their funds hold too many securities. The work would be overwhelming. Instead, they mostly rubber-stamp companies' requests.
This accusation is largely correct. It would be difficult to claim with a straight face that even the leading index-fund providers--never mind the smaller firms--are staffed to evaluate proxies from several thousand U.S. companies. Understanding the issue well enough to dissent requires time, effort, and money. Annual expense ratios of 3 or 5 basis points can only pay for so much overhead.
Then again, reports Barron's, in 2017 mutual funds of all stripes sided with management on 94% of votes. The fund industry has historically voted with its feet, not ballots. For the most part, if companies behave badly, fund managers either avoid the stock, or wait for it to become cheap enough such that its purchase is warranted. If the price is right, management's flaws can be accepted.
5) They Are Harmful Stewards
Index-fund managers dislike corporate competition. They don't want creative destruction, because inevitably, they will hold shares in the company that is destroyed. What they want instead is for everybody to succeed. They want collusion.
Now the charge is not simply that index funds police neglectfully, but that they encourage criminal behavior! Not openly, to be sure--they are too professional for that. Instead, through winks and nods, they encourage corporate managements not to beat up on each other by growing their market shares, but instead to concentrate on improving their margins. Price hikes, not price wars!
Once again, I tend to believe the accusation. And once again, it's an issue not confined to index funds. All well-diversified investors benefit when the profitability pie gets larger. In addition, even those that own concentrated portfolios should support anticompetitive strategies. If I own Coca-Cola (KO) but not PepsiCo (PEP), my best outcome is for Coke to devour Pepsi. However, the opposite could also occur, and that is my worst outcome. I therefore seek strategies that help both firms.
From Funds to Companies
Their proponents would disagree, but I regard those five criticisms as being either refuted or not yet applicable. Only the first must be discarded. The rest bear monitoring, because their concerns are at least partially justified. But they have not yet become real.
What is less clear is whether the size of the leading asset managers--as opposed the funds that they managed--should be triggering alarms. To my knowledge, nobody has attempted to state when an investment-management organization will become too large for the public good. When it owns 2% of publicly traded assets, or 5%, or 10%?
Nor have they articulated why one might worry. Concerns about asset managers' influence have been vaguely worded, as with this comment from an Oxford University finance professor. "If just a few asset managers in practice control most companies, that's not how capitalism should work. The question is when that threshold is reached. I don't know if it has, but we have to think about this now."
In truth, the index-fund debates haven't really been about indexing. They have instead involved the entire fund industry. After all, if index funds did not exist, there would still be contentions that inflows into the giant mutual funds distort and drive market prices, and that fund managers are indifferent--if not outright bad--stewards. Index funds were targeted because they were active managers' competitive threat.
Similarly, the question of whether index funds have become too big should properly be applied to investment-management firms, or perhaps the overall industry. I cannot provide an answer for that, but I do know that it should be asked of the companies themselves, rather than of the funds that they offer.