Here’s an interesting claim I see more and more often:

“The nature of ETFs and passive investment is worth noting. A vanilla S&P 500 ETF, for example, effectively puts company and sector fundamentals to one side and buys or sells 500 stocks at a time. This is fine in a rising market, but potentially dangerous in a falling market.”

The basic thinking here is that an ETF or index fund is a mindless buying and selling machine that ignores market fundamentals. So we tend to see lots of stories about how index funds and ETFs are causing this huge steady bull market in stocks and when the piper comes piping they will make the downturn that much worse. The key idea is that the product itself poses a systemic risk.

But let’s dig a little deeper because I think the fears here are vastly overstated and largely the result of misunderstanding a fairly new product and the way it works.¹ For starters, let’s look at the S&P 500.  What is this index fund exactly?  Well, it’s a rules based portfolio that is determined by the S&P Index Committee that attempts to reflect the large cap segment of the US equity market. It’s not just a mindless index. In fact, it has incredibly strict rules that were created by people:

These rules are changed at times based on how the committee determines them.  And when a security in the index fails to meet these requirements they are sold off. Likewise, new additions are determined by new entrants that best reflect the requirement rules.  These rules aren’t just fundamental. They are strictly fundamental. But we should be very clear about what’s going on here – there are people setting the rules and ultimately determining what the S&P 500 is comprised of.  If you weren’t blinded by the fake “active vs passive” dichotomy you’d look at this index fund and say it was a low fee active fund which is exactly what it is.²  Okay, so we can put aside this idea that an index fund “effectively puts company and sector fundamentals to one side”.