Are index funds evil?

It’s a feel-good story—a populist victory, as finance goes. Except there’s a problem, or might be. Over the past year or two, a growing chorus of experts has begun to argue that index funds and shareholder diversification are strangling the economy, and need to be stopped. That’s the maximalist claim, anyway, and it is a strain of thinking that is spreading with surprising speed.

Concerns about the potential dangers of shareholder diversification first surfaced back in 1984, not long after index funds themselves did. Julio Rotemberg, then a newly minted economist from Princeton, posited that “firms, acting in the interest of their shareholders,” might “tend to act collusively when their shareholders have diversified portfolios.” The idea, which Rotemberg explored in a working paper, was that if investors own a slice of every firm, they will make more money if firms compete less and collectively raise prices, at the expense of consumers. Knowing this, the firms’ managers will de-emphasize competition and behave more cooperatively with one another. Rotemberg was advised by Larry Summers, then a Harvard economist, and bolstered his argument with 30 pages of mathematical theory. But the argument was counterintuitive and lacked empirical support; his paper sank into obscurity.