Index investing is based upon a set of predefined, mechanical rules for choosing a publicly known set of stocks. The strategy of index investors is to gain exposure to the performance of the market as a whole or a particular segment of the market. Given its mechanical, rules-based nature, index investing does not require investment in fundamental research about security prices and typically entails significantly less trading activity than active investment. As a result, index investing tends to provide low-cost access to diversified portfolios.
In this report, we begin by tracking the growth of index investing in U.S. equity markets from a small niche strategy in the 1970s into an investment style comparable in scale to the active management of mutual funds. We then consider whether the rise of index investing has reduced the extent to which prices of individual stocks reflect their underlying value (price efficiency). We then examine whether the rise of index investing has increased risks to financial stability through three channels: (a) stock market bubbles and crashes; (b) concentration of asset managers; and (c) liquidity and redemption concerns. In conclusion, we find that the empirical evidence, while mixed, indicates that the rise of index investing has not had negative effects on price efficiency or financial stability. We recommend continued study of index investing in the years to come.
The full report can be found here.