Index Funds Have No Price Discovery

The beauty of index funds is that they have very little management cost to them. Such funds allocate money slavishly according to a set recipe that requires no thinking. The money flowing into an index fund is simply put into the individual shares that the index is composed of.

This means that no analysis of the individual stocks is made when money is allocated to them. There is no price discovery. The task of price discovery is left for others to do. As a consequence, whenever index funds become dominant for a particular group of shares, the price of each individual share will be determined more by the flow of cash in and out of the funds than the performance of the companies.

A great influx of cash into index funds will cause share prices to rise irrespective of the overall performance of the companies. Conversely, any great outflow will cause share prices to fall.

What is important to judge for a short term investor considering buying into shares that are dominated by index funds is therefore the availability of cash. If cash is easy to come by, shares in index funds will go up. If cash is hard to get, prices are likely to fall.

The performance of the individual companies are secondary to the cash flow of the index funds. As a consequence, shares can be overpriced for decades on end in periods of monetary expansion. In periods of monetary contraction, they can for the same reason be under-priced for long periods.

However, in the long run, prices always return to their historic average. The long term investor can therefore safely buy into stocks whenever stocks are under-priced, and a safe and cheap way to do this is to buy index funds.

Crowd outside NYSE 

By US-gov - From an SSA poster: http://www.ssa.gov/history/wallst.html, Public Domain, Link