In July 2016, the Standard & Poor’s 500 index (S&P 500) hit a new high, just five months after one of the worst one-month market declines on record. From its February low, the S&P 500 index has gained 16%, brushing off the dreaded Brexit vote and ignoring the threat of a weakening global economy. For many market observers, it raises the question as to what could be fueling this aging bull market, now in its seventh year, when most signs indicate that the bull market may have run its course. According to some market experts, the answer lies in the continuing surge of flows into index funds, which may be inflating valuations well beyond intrinsic measures, while creating a double-edged sword for passive investors.

Massive Inflows Continue for Index Funds

The growing popularity of index funds has coincided with the continued underperformance of active funds. Index fund investors are realizing better returns at a fraction of the cost as active fund managers struggle to maintain their relevance.

According to Morningstar Inc. (MORN), investors yanked nearly $22 billion from actively managed stock funds in June 2016, which was the largest monthly withdrawal since October 2008. A total of $30.3 billion was pulled from all actively managed funds, with most of it, more than $29 billion, finding its way into index mutual funds and exchange-traded funds. The gulf between active equity fund outflows and inflows of their passive equivalents reached nearly $500 billion in 2015, with $89.3 billion flowing out of active equity funds and $398 billion flowing into passive equity funds.

Leading to Index Stock Overvaluation

Some experts argue that the positive performance of index funds in relation to active funds can be attributed to the relentless surge of the six-year bull market. In a rising market, it doesn’t require active management skills to generate positive returns. However, as the bull market is reaching its late stages, even as fundamental and technical indicators signal otherwise, its continued strength is being attributed in part to the surge of flows into index funds. The billions of dollars flowing into index funds each month have to be invested in an index, which means that fund managers are indiscriminately buying up shares of stocks listed in the index and holding them. Because the stocks in the major indexes are weighted by market capitalization, the larger stocks are buoyed much more than the smaller stocks in the index. However, all index stocks are lifted by the package purchasing of index fund shares, including companies with weak balance sheets and earnings.

As market experts explain it, the massive movement of funds into index funds is distorting market valuations by forcing index fund managers to buy index stocks in enormous volume. The mere inclusion of a stock in a major index can distort its price to a certain extent. However, the current valuations of stocks in the S&P 500 Index and the Russell 2000 Index are bloated beyond their intrinsic values, with premiums that far exceed stocks outside of the indexes. In a study done by S&P Capital IQ, Russell 2000 index stocks carry an average price-to-book value ratio of 2.16 versus a 1.34 ratio for nonindex stocks, which translates to a 61.9% premium. This suggests that index stocks are overvalued in comparison to the overall market and that index stocks are as dependent on their inclusion in the index as they are on fundamentals for their performance.

The Double-Edged Sword of Index Fund Investing

While investors benefit from the massive flows of funds into passive equity funds, they may find themselves on the wrong side when the stock market finally succumbs to the bubble of overvaluation. Overvalued stocks tend to fall harder and faster during a correction. During the Black Monday crash of October 1987, index stocks fell 7% more than non-index stocks. Similarly, in the August 2016 sell-off, Russell 2000 stocks fell more sharply than non-index stocks. The disturbing aspect of this is the increasing correlation of index stocks to nonindex stocks in those corrections, which calls into question the advantage of diversification with index funds. Of greater concern for investors, the August downturn revealed the potential liquidity risk of owning index stocks through exchange-traded funds (ETFs), when trading was halted multiple times during periods of high volatility, preventing investors from liquidating their shares in a timely manner.

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