Ben Johnson: Index Funds Are Not 'Zombie Investors'

Episode Summary

Executive Summary: Morningstar’s Ben Johnson argues indexing grew from a fringe idea into a global force because of lower costs, changing advisor incentives, and broader access to markets. He says index investing is not a market bubble threat, but governance and investor expectations matter. He also explains where indexing works best, why bonds and some factor strategies are less suited, and how the industry is shifting toward model portfolios and holistic solutions.

Main Topics: Why indexing has grown so rapidly (Priority: 5/5): Johnson traces indexing’s rise to changing attitudes toward paying less, advisor fee-based business models, and default options in retirement plans that favor low-cost portfolios. Global adoption and regional differences (Priority: 4/5): Indexing is a global trend, but adoption depends on distribution structure and regulation; markets with bank-dominated channels have lagged compared with the U.S., UK, and Australia. Whether indexing is a bubble or harms price discovery (Priority: 5/5): Johnson rejects the idea that indexing has become a bubble, arguing indexed assets still represent a small share of trading volume and do not meaningfully impair price discovery. Governance concerns and stewardship (Priority: 4/5): He acknowledges concerns about voting power concentration among large asset managers, but says Morningstar research finds passive managers are active stewards rather than 'zombie investors.' Where indexing works best and where it struggles (Priority: 5/5): Equities, especially U.S. large caps, are highly indexable; high-yield bonds and some credit-heavy fixed-income areas are less suitable because indexes exclude much of the opportunity set. Factor investing, strategic beta, and investor behavior (Priority: 4/5): Johnson says factor strategies are useful but often overhyped; their real-world payoff is diluted by implementation costs and long droughts, while investor flows often chase recent winners. Industry consolidation, fees, and the future of asset management (Priority: 4/5): Fee wars may be nearing their limit, pushing firms toward model portfolios, software/tools, and bundled solutions rather than stand-alone fund sales.

Key Arguments: Indexing succeeded because it offers market exposure at very low cost, and costs are a major determinant of long-term returns. Advisor business models shifting from commissions to fees structurally favor low-cost indexed products. Defined contribution plans and target-date funds have become major conduits for index adoption because they encourage consistent, automated investing. Indexing is global, but markets with concentrated bank distribution and entrenched channels are slower to adopt it. Despite high index-fund ownership, index funds are still a minority of total trading volume, so they are unlikely to distort prices meaningfully. Morningstar’s view is that large passive managers are engaged owners, not passive 'zombies,' because they must vote and monitor portfolio companies. Breaking up index funds or imposing artificial ownership limits would reduce diversification, raise costs, and harm investors. ETF investors are hard to study because ETFs are used by both long-term allocators and active traders, making flows difficult to interpret. ETF trading commissions dropping to zero is largely neutral for behavior because traders will still trade and non-traders already faced low or no costs. Indexing works best where the opportunity set is broad, liquid, and representative; it works less well in less liquid or more idiosyncratic markets like high-yield credit. Factor investing in real portfolios is weaker than in academic papers because long-only implementation, trading costs, and taxes reduce returns. Many investors are chasing factor strategies after strong recent performance, especially low-volatility and dividend-focused ETFs. The industry is moving toward model portfolios and holistic solutions because plain-vanilla index products leave little room for differentiation.

Data Points: U.S. indexed equity mutual fund assets overtook active: recently - Used to illustrate the maturity of indexing in the U.S. equity market Growth of indexing in the U.S.: past decade or so - Johnson says the most rapid leg of growth has been in roughly the last ten years Fee threshold for broad stock/bond portfolio: less than 10 basis points - He says investors can now own virtually every stock and bond on the planet for under 10 bps Zero-fee mutual funds: Fidelity brought out a line of zero-fee index funds - Cited as evidence that fee wars are nearing their practical limit 401(k) contribution pattern: bi-weekly contributions - Referenced as part of the 'set it and forget it' behavior in retirement plans ETF commission change: $4.95 to zero - Schwab’s elimination of commissions on ETFs and other investments Strategic beta share in U.S. equity ETFs: about a fifth of assets under management - Johnson cites this as Morningstar’s definition-based estimate in equities Big passive asset managers: BlackRock, Vanguard, State Street - Named as the largest firms whose voting power concentration draws governance concerns Past performance window: past 10 years - Described as a period of benign markets and strong index-fund performance that may create complacency Retail distribution review (UK RDR): commission payments banned - Used as an example of regulation accelerating passive adoption in the UK High-yield bond ETFs mentioned: TLT, HYG, JNK - Examples used to show ETF liquidity and market usage in rates and credit Vehicle comparison: 3 common ETF benefits: low costs, tax efficiency, tradability - Johnson explains why these are less compelling inside 401(k)s Target-date/401(k) behavior: qualified default option - Target-date funds are described as the default that drives disciplined investing Strategic beta within fixed income: relatively low penetration - He says adoption in bonds remains small compared with equities

Pivotal Quotes: "the less you pay, the more you're likely to get" — Ben Johnson: Explaining the core cost advantage behind indexing "we're a very long way from having to be worried about any sort of distortionary effects that indexing... has on the markets" — Ben Johnson: Addressing concerns that indexing has become a bubble or harms price discovery "they're anything but zombie investors" — Ben Johnson: Describing passive managers’ proxy voting and corporate engagement efforts

Implications: Investors should expect continued growth in low-cost indexing, but should match tools to markets and stay wary of chasing recent winners. The industry is likely to shift toward model portfolios, while governance and hidden costs will matter more than headline fund fees.