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Summary Index funds have grown fantastically in popularity, and in 2014 received over half of inflows to equity funds. Data suggests that index funds outperform during bull markets, but not during bear markets. Index funds have become extremely popular, perhaps a bit too popular for both the health of your portfolio during current market conditions and the long-term implications to the stock market. The recent return of volatility to the market – multiple days where the major averages gained or lost several percent – has revealed a lot about the stock market that years of slow, grinding gains managed to camouflage. Index funds have become the “new religion” of the stock market, but they may not be the panacea that many think. In particular, they may pose a danger to the value of your investments under current market conditions. The Growth of Index Funds Index funds have been around for decades. Vanguard introduced its Vanguard Five Hundred Index Fund (MUTF: VFINX ) in 1976. Enthusiasm for indexing remained muted for years, but in 1992 the Amex went a step further and created the S&P Depository Receipts Trust Series 1, or “SPDRs.” These proved extremely popular, and many other Exchange Traded Funds (“ETFs”) soon followed. The allure of ETFs that mirror an index is obvious. They remove human error and, more importantly, the expense of active management. The real benefit, though, is the fact that securities linked to an index provide an “average” performance that beats that of the majority of active managers. The media loves to tout that passive investing beats active investing up to 85% of the time. Warren Buffett famously advises non-professionals to dump their money into index funds. Even those arguing in favor of active management, such as Wealthfront Knowledge Center, must admit that during bull markets, index returns beat those of most active managers. So, this is not an attack on index funds. They have their place. However, there is more to the story than simply assuming that index funds will remove all investing concerns. Burton Malkiel, whose “A Random Walk Down Wall Street” is one of the classics of investing, studied why index funds are better investments. He concluded that the primary reason is simply the extra costs associated with active management. Otherwise, they offer similar performance. There are good reasons for passive investment. Many, if not most, investors, don’t have the time or inclination to ascend the steep learning curve required to become a successful investor. They have their own careers, own lives, and not everyone is entranced by the wonders of the stock market. While one might think that the growth of the Internet and extremely low commissions relative to the past would lead to individual investors becoming more active investors who take matters into their own hands, it seems that the opposite is taking place. Why this is happening is a complex problem. Perhaps the inundation of random facts and opinions about stocks now available on the Internet has the perverse (or perhaps salutary) effect of making amateur investors realize how little they (or their advisers) really know about how stocks will do. From its humble origins in the 1970s, index investing recently has mushroomed. As of year-end 2013, it accounted for 35% of equity funds and 17% of fixed income funds. In 2014, 55% of money invested in equity mutual funds went to index funds. Obviously, if the asset base of equity funds was 35% in index funds, but the marginal contributions constituted 55%, the popularity of index funds is growing quickly. One could almost call it a “bandwagon effect.” There is very good reason to be leery about something that provides such an attractive lure that seems to cure all investing problems. Why This Trend is Dangerous It is easy for investors to look at the research showing the out-performance of index funds, throw up their hands, and bypass active management. I myself like index-based funds. They make sense for good returns without too much effort, and the data supports that. The problem is that they make too much good sense. This was masked for several years due to the gradual rise of the U.S. markets since the 2008-2009 recession. Basically, the stock market during these past few years was a “one decision” project. If you bought during periods of market weakness, the market quickly sent the averages to new highs. We can argue about the reasons, but the slow, steady, unflinching march higher of the S&P 500 and other major indexes in recent years made active management basically superfluous. Why pay the additional costs of active management if everything is going up? While making perfect sense for the individual investor, for the investing class this seemingly ironclad line of reasoning could lead to poor results in the future for a couple of reasons. First, index funds do not perform well during bear markets. In fact, a study found that during bear markets, an S&P 500 index fund beat only 34% and 38% of its active management competitors. That means that the “cruise control” of index funds will send you into the ditch just at the wrong time. Second, index funds rely on the pricing of their components for their own pricing, but that pricing can be questionable at times. This may seem trivial, but it can hurt you in unexpected ways during illiquid markets. On Monday 24 August 2015, when the Dow Jones Industrials opened down over 1100 points, many stocks didn’t open until well after the open. Market makers basically had to “guess” at the prices of their stocks. Old-time market participants will recall the same thing happening during the 1987 market break, and during others. This type of volatility leads to “pricing havoc” of index ETFs, as happened on Monday. That may sound terrific if you wanted to buy an ETF at a weirdly low price, but not if you were selling. Third, the growth of index funds appears to be turning the market into a binary casino. Now, it is hardly new to disparage the market as a random casino, that has been going on for as long as stock markets have been around. However, decreasing the role of active managers means the market increasingly leans toward becoming an “all or nothing” bet. If people are selling, then everything sells off at once, and vice versa. Bob Pisani at CNBC noted that there were wild swings of “panic selling” and “panic buying” during the big Monday morning rout, something he had never seen before. He mentioned that there were “strange numbers” in the market, such as only two new highs and 1200 new lows, and 120 stocks advancing while 3100 were declining. Was this due to the influence of all-or-nothing indexing decisions? That could have been a contributing factor. If you were holding an index fund, that would have directly affected pricing of your holdings, quite possibly to your detriment if you had chosen that time to sell. A glance at the chart shows how bizarre some prices were that morning. Fourth, if you don’t have active managers and sufficient numbers of investors in individual stocks, on what exactly are the indexes going to be based in the future? This is more of a longer-term problem, but if you don’t have millions of individual decisions being made about individual securities every day, the market is only going to become more binary and treacherous. The only thing left to determine its course, really, will be economic government data at a macro level, with individual stock prices set basically by the index funds. The individuality of the market will lessen, and as things become more “standardized,” you can count on returns decreasing. Conclusion Index funds make good sense for the individual investor – too much good sense at times. I use them myself, as do many professional investors. However, hidden dangers lurk both in the short term – if the market suddenly stops rising year after year – and long term. They can be dangerous to your financial health during times of market volatility. There are many ways for the individual investor to shield themselves from these sorts of dangers, but ignoring them is not one of them. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.