I can't help but notice the popularity of index mutual funds over actively managed funds. I think all the arguments are sound, but I have one worry:
Index funds are run by buying the stocks listed in a particular index, with the goal being to get the fund performance to track the index performance. Now if all this money starts pouring into index mutual funds, doesn't that mean that the demand for stocks that are listed on an index will go up, but the demand for stocks not listed will be stagnant (or drop due to money being moved from actively managed funds)?
Will this not create a pricing bubble for these stocks? If I'm holding index mutual funds because they're popular, won't I see a big drop in value when the "smart money" pulls out?
One possible answer to this, from a technical sense, would be to point out that the amount of money in index funds is much, much less than the total money invested in those stocks (like 1/1000th) and so any price inflation would be tiny. However, I don't know how you'd dig up that information.
There is evidence that even being included in an index will affect a stock's price, as will de-listing it:
Papers investigating Standard and Poor’s 500 Stock Index (S&P 500) composition changes over the 1976–88 period ﬁnd a change-day positive (negative) abnormal return of approximately 3% (1.5%) for additions (deletions).
Also, from here:
Many mutual funds and exchange-traded funds (ETFs) are based on various stock indices. When an index is rebalanced, the funds must sell the deleted stocks and buy the added ones in their portfolios. Fund buying often causes short-term volume and price spikes in the newly-added stocks. After the flurry of buying activity generated by index rebalancing, the stocks go back to trading based on their fundamentals. However, investor inflows into mutual funds and ETFs can push up the prices of all stocks in an index, in the same way that investor outflows can push them down.
An index may announce changes to its composition ahead of time. For example: On the 15th of the month an index publishes stock deletions and additions effective on the 1st of the following month. Index funds cannot make any changes to their portfolios until the index is officially changed, but speculators may start buying the new additions right away, reasoning that the funds will have to buy them later at any price. Speculator front running can cause the prices of stocks being added to increase prior to the official rebalancing date.