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I have read an article and watched a couple of videos about a possible index fund bubble.

One of the arguments to justify this bubble is (if I have understood it correctly) that a very huge proportion of the market being hold by index funds affect the price discovery, since large cap companies in indexes (like S&P 500) could be overvalued against the small cap ones.

If the above is true, correct me if I'm wrong, but indexing is not the problem itself. The problem would be that the majority of investors would buy 'popular' indexes such as S&P 500. If investors were split equally in different cap indexes, then the price discovery problem disappears, right?

I have read as well that despite of index funds hold a very huge part of the market, what actually does price discovery is trading, and index funds usually don't have very high turnovers, so they aren't actually distorting large cap stocks. Is this correct?

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Price discovery is enough number of traders who study fundamentals and influence the price.

Index funds and large diversified funds work on pre defined algorithms... There is some decision making in large diversified funds, but as fund manager can't monitor every share, in reality only small percentage of shares are actively managed by the fund manager...

Assume there are only 2 share in an Index, only 10% of shares are with Index funds. As index funds passively invest, they amplify the price movements, i.e. if the price is going up and there are more buyers, Index funds would buy more shares, resulting in slight up tick...

If there is large percentage of stock with Index funds the amplification is large and can get into vicious cycle. Say 90% is with Index funds... A small distress sale by individuals can bring the price down as there are not enough buyers, this lower price can trigger index rebalancing or some individuals holding the funds selling the mutual funds with out any new mutual fund buyers... This sale will again lower the price... And the cycle can very quickly get the price artificially down...

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Your final point is the most important factor in this discussion, and one that is often overlooked.

Changes in prices, and hence price discovery, are driven by trades, not by volume of ownership. Obviously, someone who's merely owned shares in a company for the last decade (without buying or selling more) has not participated in setting the price of the shares since their purchase.

While a large percentage of the market may be held by index funds, the majority of the trades are still made by individual investors. The sale or purchase of an ETF, for example, does not necessarily or usually result in the sale or purchase of the underlying asset.

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  • However, index funds are rebalanced every 'n' months. That is trading. Can't this cause some sort of 'inertia': a stock (contained in the index) goes down and, when all index funds rebalance, they magnify this effect. The same when a stock goes up.
    – Martel
    Commented May 13, 2020 at 9:36

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