The Potential of an Index Fund Bubble

Tulip bulbs are a very unique creation. Their flowers are known for being nearly perfect in their symmetry and you can find them in almost any color. Their blossoms let us know that spring has sprung!

Yes, this is still the Greater Than Financial column. I mention tulips because tulip bulbs were a key player in one of the greatest asset bubbles in history: Tulip Mania. It happened in the Netherlands in the 17th Century.

Tulips are certainly beautiful, but the prices in the 1600s got really crazy. A single bulb was known to trade for 6 times a person’s average annual salary. It was nonsensical, but many got caught up in the excitement and the quick money opportunities the bubble brought. 

You could have asked most rational people what the “true” value of a tulip bulb was, and most would agree it’s not worth close to 6 years wages. But that didn’t keep people from willingly paying extreme prices for bulbs. 

There are a lot of economic and sociological aspects to Tulip Mania. But there is a lesson (actually many of them) for everyone. The most important lesson is that the functional value (meaning how a good/service fulfills our practical needs) of an investment does not alway rationally correspond to the price of that investment. As was the case with tulip bulbs.

That’s also often the case with gold. Gold can be used in industry, and it may be the best for certain uses, including electronics. But because of gold’s history as a store of value, gold’s price doesn’t typically reflect its practical daily value. Most of the price of gold is tied to the speculation that gold has historically been used as a way to keep currency value in check (a store of value). Although the US dollar isn’t tied to gold right now, it could be again one day, and therefore investors speculate on its value.

I don’t own any gold and I don’t own any tulip bulbs. I have never recommended to my clients to buy gold or tulip bulbs. That’s not a prediction of their future prices. It’s simply my principle. 

However, I have recommended to many clients, based on their unique personal situations, to buy VOO, which is an Exchange Traded Fund (or ETF) called the Vanguard 500 Index Fund. It aims to buy approximately 500 large cap (meaning worth more than $10 billion) US companies. 

(Fair warning: now leaving Financial Planning 101)

The question then becomes: are we making a similar mistake with S&P 500 passive index funds, like VOO, as was made during Tulip Mania? Because of the research supporting passive index investing, and because of the ease in buying a passive index fund like VOO, has it created prices that no longer correspond to the functional value of the companies that actually make up the S&P 500? If yes, does that mean there is an indexing bubble? And if yes to that, will it ever pop? And if yes to that, when? And what should or even can we do about it?

And this is my favorite way to end articles. Present a bunch of deep questions, then leave the reader hanging. See you in two weeks!