Everywhere you go these days you hear yet another investor singing the virtues of investing in low cost index trackers. Frankly the sales pitch makes sense doesn't it? It's very easy to understand and goes something like this:

"The majority of active fund managers underperform the market averages so why should you pay 2% for the privilege? If you buy an index fund you can guarantee average performance and thus beat the average fund manager."

It seems that this idea is winning. The mainstream press sings the praises of low cost passive investing, while the knives are out for active fat cat fund managers. Meanwhile a Tsunami of money in the fund management industry is flowing into passive vehicles, and the flow of funds into the big providers like Vanguard is quite astonishing. The advisory community is voting with its feet and has decided that index investing is the light.

But my nostrils have started flaring from a growing stench of groupthink and I can't help thinking that somehow this is all going to end in tears.

The ultimate piggyback ride

In a way, index investing is the ultimate piggyback ride on the coattails of the active management community. If you think about it, the selection of stocks that are included within the major indices is solely due to the discerning opinion of the active management community. These professionals bid the price of a stock up until it becomes a candidate for promotion to the relevant major index - such as the FTSE100 or S&P500. At this point index funds jump on the bandwagon and buy. The idea that this is a 'passive' process is beyond me - it's an active decision to ride on the coattails of other people's decision making.

The irony is that index funds haven't had to pay the salaries of the people who pick their stocks for them. Index investing has been monstrously successful partly due to the fact that through this trick they've kept the costs of management extremely low. If there were any justice index funds would pay a tax to the active management community for their service.

But piggybacking can only be a successful strategy if you don't get too heavy for your ride. As index investors have started to dominate the stock markets they have started to create some terrible unintended consequences. The horse's knees are starting to buckle.

When success…

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