Index funds have gone from niche experiment to default choice for millions of investors. They promise low fees, instant diversification and a simple way to track the market without sweating over individual stocks.

On the surface, that sounds like a rare win–win. Recent academic research, though, suggests there may be a hidden catch.

As index funds become cheaper and more popular, they may be changing how the entire market behaves. That shift could gradually reduce future returns, not just for new investors but for long-term participants as a group. Understanding this tension can help you use index funds wisely instead of blindly.

Index funds 101

An index fund is a pooled investment vehicle built to mirror a specific market benchmark, such as the S&P 500 or a total stock market index. Instead of hiring a manager to pick “winners,” the fund simply buys all (or most) of the stocks in the index in their respective weights.

This structure gives everyday investors exposure to hundreds of companies at once. A single purchase can spread risk across different sectors, sizes and business models. For someone who does not have the time or skill to analyze individual companies, this broad approach is a powerful shortcut.

Over long horizons, index funds have tended to beat most actively managed funds. Many long-horizon scorecards have found that only a small fraction of large-cap managers outperform the S&P 500 once fees are included. That gap is a major reason index investing exploded in popularity.

Why they dominate

Costs are a big part of the story. Many broad index funds charge expense ratios measured in a few hundredths of a percent per year. Actively managed mutual funds, by contrast, often charge ten to twenty times more. Every extra fee comes directly out of your returns.

William F. Sharpe, an economist, writes, “Before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar.”

Index funds also offer clarity and predictability. Investors know what they own, how it is selected and why performance tracks the benchmark. There is no mystery “secret sauce,” just the market itself. That transparency helps investors stay disciplined during rough patches.

Finally, index funds are behaviourally friendly. Because there is no star manager to follow or hot idea to chase, there is less temptation to jump in and out based on emotions. Many people simply set up automatic contributions and let time and compounding do the heavy lifting.

The new concern

Oxford’s Martin Schmalz and UCLA’s William R. Zame modeled what can happen when indexing becomes extremely cheap and widely adopted. Instead of looking at one investor’s experience, they focused on the system-wide effects.

Their conclusion was not that index funds are scams or that investors should abandon them. The message is subtler: when huge amounts of money flow from safer assets, such as bonds, into broad stock indexes, the buying pressure pushes stock prices higher.

If prices rise while companies’ underlying earnings do not, future expected returns drop. Investors end up paying more today for the same stream of profits tomorrow. That means the long-run reward for owning stocks can gradually shrink as indexing becomes more dominant.

Crowding and returns

Think of this as a crowding effect. Index funds make it easier and cheaper to own the whole market, which encourages more people to do exactly that. Although each individual may be acting sensibly, the collective impact can drive valuations up.

Higher valuations are not automatically bad. Part of the rise in prices over recent decades reflects real growth and innovation. The research highlights a different piece: the portion of price gains that comes purely from more investors piling into the same broad basket because it is cheap and convenient.

From that perspective, the traditional message “index funds are always better for everyone” misses an important nuance. Index funds can still be the smartest tool for a typical household, yet the presence of huge index flows may mean that the overall market return is lower than it would have been if indexing had never existed.

Good for you, not perfect

This tension creates an odd situation. As an individual, choosing a low-cost index fund still often beats trying to pick stocks or paying high fees for active management. But when almost everyone makes that rational choice, the aggregate outcome can be less attractive.

In other words, your personal decision can be right even if the system outcome is less than ideal. Index funds remain especially useful for people who:

• Want broad stock exposure without constant research

• Prefer low, predictable costs

• Value a rules-based, emotionally simple strategy

At the same time, the research is a reminder to temper expectations. If valuations stay elevated, future returns may be more modest than the past decade’s double-digit numbers.

Balancing your portfolio

So what should an investor actually do with this information? The answer is not to abandon indexing and chase complex products. Instead, it is about building a more balanced, realistic plan.

First, treat index funds as a core building block, not the only tool. Combining a broad stock index with quality bond funds, cash reserves and possibly other diversifying assets can reduce the impact of any single market trend.

Second, diversify across more than one equity index. Relying only on a single benchmark, such as a large-cap U.S. index that is heavily tilted toward one sector, concentrates risk. Adding international or small-company indexes can spread exposure more evenly.

Third, pay attention to valuations and your time horizon. If stock prices are high relative to earnings and you are close to needing your money, it may be wise to lean a bit more on safer assets, regardless of what index funds have returned recently.

Practical next steps

For many people, a simple approach still works well: choose a low-cost total market index fund or a mix of broad stock and bond index funds, set an asset allocation aligned with age and risk tolerance, and rebalance periodically. Investors who have larger portfolios or complex goals might add a few carefully selected active strategies or factor-based funds on top of that core, accepting higher costs in exchange for potential outperformance. The key is to do this intentionally, not because of fear or hype.

Above all, remember that index funds are tools, not magic. Low fees and diversification tilt the odds in your favour, but they do not override basic market realities. Expected returns change over time as prices move, and the popularity of any strategy eventually shapes the environment it operates in.

Conclusion

Index funds transformed investing by making diversification cheap, simple and accessible. Even if their massive success has pushed stock prices higher and may trim future market-wide returns, they remain a strong option for individual investors who want a straightforward, low-cost way to build wealth.

The real opportunity is using index funds as a disciplined core, while keeping expectations realistic and pairing them with other assets that match your timeline and risk comfort.