That diversification is a bit of a smoke-screen though. The most popular index funds are cap-weighted. This causes the allocation of capital within the fund to become increasingly dominated by those few winner-take-all companies.
When index funds grow to huge levels of assets under management, their own asset allocations come to make up a significant portion of the market cap of the stocks in the portfolio. Thus the cap-weighted investment strategy becomes a self-fulfilling prophecy.
> Thus the cap-weighted investment strategy becomes a self-fulfilling prophecy.
Either you’re doing the math wrong or you’ve skipped some steps.
Let’s say you have companies X and Y, each with 50% of the market. X is a winner, and the stock price goes from $10 to $45. Y is a loser, and the stock price drops from $10 to $5. The new weight is X=90% and Y=10%.
But this cannot be a self-fulfilling prophecy for index funds, because the index funds do not have to buy or sell any shares of X or Y to keep up (I mean rebalance, specifically). In this scenario, the index funds are just holding. (By “holding” I mean “not rebalancing”.)
This is… an oversimplified scenario. But it illustrates the problem here with the “index funds cause a small number of stocks to be winners” theory. There are alternative theories that make sense, but not this one.
(What makes the scenario more complicated is when you think of buybacks, dividends, delisting, etc.)
Obviously, but the point here is that cap-weighted index funds convert new money into buyers-at-any-price of their components.
When they're more concentrated in specific holdings, and have enough new money, wouldn't that artificially support higher prices for those holdings (above what the market would otherwise bear)?
Why not flip the argument, and say that the index fund is propping up stock B because of it's buy-at-any-price nature? What makes you think that valuing it at 10% of A isn't higher than what the market will actually bear?
The sensible and consistent way to this is that... Index funds don't really have any effect on relative stock prices. If stock A is overvalued or undervalued, it's due to active investors being morons.
Don't index funds trail market changes though? I thought their allocations are reactive. In other words, the Mag 7 are being bid up by people trying to beat the market. I don't see how index funds could move prices.
I do understand how they can stabilize allocations where they are, which I think is the concern. Zombification rather than a positive feedback loop.
When index funds grow to huge levels of assets under management, their own asset allocations come to make up a significant portion of the market cap of the stocks in the portfolio. Thus the cap-weighted investment strategy becomes a self-fulfilling prophecy.