Opinion: Bill Ackman actually had a point with his index fund bubble theory

A lot of mutual fund investors heard the phrase “index fund bubble” for the first time this week.

Without knowing what one is, what it could look like or the motives of the famous money manager who made news using the term, investors had reason to worry. Bubbles typically meet an unhappy end.

The question is whether investors should be fearful, especially in a market that has so many readily visible hot spots seemingly about to burst into flames.

Bill Ackman, activist investor, philanthropist and the top dog at Pershing Square Capital, floated the index fund bubble idea in his letter to shareholders dated Jan. 26. His critics passed it off as a smokescreen, a way to divert attention from his worst-ever year of performance, a 20% decline inflated by a badly miscalculated headline-making wager against Valeant Pharmaceuticals VRX, +4.76%

Reading Ackman’s letter, however, he had several interesting points that index investors should at least consider, because they raise the specter of shaky portfolio bedrock.

After acknowledging some reasons for his hedge fund’s “continued negative outperformance” (translation: “losses longer and bigger than other guys’ ”), the billionaire activist investor ripped index funds.

It’s complicated, but his objections boil down to:

1. As money flows into index funds, it bloats the value of the stocks within the benchmark compared to stocks that are outside of the index. This creates/inflates the bubble Ackman is talking about.

2. Index funds not only follow indexes, but encourage active managers to stay close to the index, a phenomenon called “closet indexing,” where investors pay for active management but get index-like results because the fund company fears shareholder reaction if returns deviates sharply from the benchmark.

3. Passive ownership by the biggest names in indexing — specifically Vanguard, BlackRock BLK, +5.04% and State Street STT, +7.21% — hurts investors by keeping corporate managers in place. It concentrates corporate power in a small group of players who get larger by the minute — 20% of all fund flows currently head into index funds — and who look out for one another’s interests.

Read: Dear hedge funds: Index funds didn’t cause your lousy performance

This is the activist, Ackman, suggesting that the passive investors are pacifists, voting only with whatever corporate management wants done. (Clearly, his pet causes would be easier if the big boys stood ready to vote for his side.)

“If the index fund trend continues, and it looks likely to do so, what happens when index funds control Corporate America?” Ackman wrote.

He noted that Japan’s system of cross-corporate ownership — like the tightening circle of index powers — has been blamed for decades of lagging corporate and economic results, and “large passive ownership of Corporate America by index funds risks a similar outcome,” he said.

Also read: Bill Ackman’s Pershing Square is down 11.4% so far in 2016

The trend toward indexing will continue for the foreseeable future. Index investors have recognized that they want to capture market returns over long stretches of time, and trust the market’s ability to stay ahead of most stock jockeys rather than believing a typical manager can deliver superior results.

So let’s see if Ackman’s concerns are likely to, indeed, bubble up.