So I won't tell Floyd Norris he's wrong, but I will say this: There's just no statistical way you can "blame" index funds for the blow-off of the market in 1998, 1999 and early 2000, because they're only doing about four-tenths of 1 percent of all the trading. And GE … actually, they happen to be one of the stocks I looked at in this study ... and our portion of GE's volume in the year 2000 was four-tenths of 1 percent. So index funds aren't a great contributor to the efficiency or inefficiency or whatever you want to call it about the market.

Blitzer: I guess I take a slightly different tack. Sometimes instead of calling it passive investing, I like to call it intelligent investing. But there's another activity out there called human greed, and there's a sense, if this proportion were to rise, the potential returns to picking stocks and getting them right would go up at the same time. So in that sense, I think greed will balance out the possible diminishing marginal results of indexing if it gets too big.

Norris: One of the things that first made me wonder about indexing was when I used to be the stock market columnist at Barron's and would write about the market at great length every week. I would write about stocks that were up 3 percent or 4 percent for the week because they were added to the S&P 500. And it occurred to me that to some extent, whether you're in or out of the S&P 500 says nothing; nothing changed that week on the company that went up 4 percent. Its business did not get better or worse in any way that was noticed. [The reason it went up] of course was because everybody who had to match the index had to flood into the stock. And that, I think, is a sign that there is some effectiveness even at the current levels of indexing.

Blitzer: Yes, stocks do go up when they're added to the S&P 500 typically; not reliably enough that I'd recommend anybody betting on it, but typically they do. Nowadays, when companies run buyback programs, their typical active buyback buys 1 or 2 percent of the outstanding shares over 13 weeks. Add the stock to the S&P 500, and 10 percent, five to 10 times that amount, is bought up in a period of about two or three weeks. But if you look further, it goes up and then it drifts back down, so if you look six months later, there really isn't any effect. It's not much different than the buyback program except the stock is really still out there, whereas in the buyback, the stock is retired.

Bogle: In my new book, I say the stock market is a giant distraction in the business of investing. Think of all the investors in America in two groups: long-term investors and short-term investors. And long term, they all own the same stocks. But the long-term investors don't trade with each other; they don't trade with anybody. They own those stocks forever, and they capture the earnings, growth and ideals of American business. And the short-term investors capture the same returns because they own the same stocks, but by all that swapping back and forth they incur a lot of cost—management cost, transaction cost, tax cost, frictional cost, and the list goes on and on and on. And they lose by a substantial amount. By definition, long-term investing must and will forever outperform the folly of short-term speculation. It's simply in the relentless rules of humble arithmetic.

Shiller: On the other hand, this speculative spirit that we have in America is, in another sense, a treasure. Ultimately, we're the most entrepreneurial country. We may be losing resources in too much trading of stocks. On the other hand, we have lively markets and price discovery that benefit from this. So I think it's a partial truth. I couldn't see us telling everyone just to invest in an index fund. Maybe that's good for most individuals, but it's not the overall advice that you give to everyone.

Wiandt: Yeah, I think Floyd tapped on something that resonates with a lot of people, and that is that the very largest stocks in the market are the ones that are most heavily weighted by the index. So my question to the panel is, does cap weighting make sense? Does it still make sense as a way to hold the market?

Blitzer: Yes, I think it does still make sense. The market is cap-weighted, and if you want to achieve the results of the market as the efficiency of holding the market, I think it should be cap-weighted.

The argument is very simply that all those big stocks, as they get bigger and bigger, get overvalued, and they're going to go down. If you look at all the stocks, some are overvalued, some are undervalued, and all the trading that Floyd is anxious to see will gradually reveal that—sometimes very quickly, maybe not for years. If you dig into it, a couple of things that I think finance tells us is, small stocks tend to do better than big stocks in the long haul, probably because of all the entrepreneurial attitudes and skills in the United States. And deep-value stocks, which really nobody wants and therefore probably are undervalued, tend to do better than the average. You can tilt the index that way; it's been done; we do it; our competitors do it; it's very easy. But I think that's what all these fancy schemes, or elegant weighting methods, if you like that better, are doing. I think they're playing what various researchers have found: that small value stocks do better.

Bogle: Well, I for one find myself absolutely appalled by the number of products that are thrown out on the unsuspecting public. In the good old days, this was an industry that sold what we made, and we became an industry that makes what we'll sell. So when the ETF entrepreneurs come into the business, what do we get? I think the number is now 690 ETFs, and 12 of them are classic index funds. And there are so many wild funds out there, like commodity funds, but they're all designed to catch a wave, to attract the public. What used to be a business of management has become a business of marketing, and ETFs are just one more manifestation and an extreme manifestation of it.

So it's a great big marketing scheme, everybody trying to out-market the other person.

Moriarty: Well, I do think a lot of these people think they really do have a better mousetrap. For instance, with HealthShares, Jeff Feldman really believes that there is going to be exponential growth in the health industry between the aging population of the boomers and the increase in technology and what have you, and that people are going to be more and more sensitive as they have more and more money to fix every problem known to mankind. And he really believes that that's an area that's going to grow in excess of the average market, and he thinks that he has a vision that other people might be interested in, and he thinks he should be able to offer that investment. So I think that it's not completely cynical.

Norris: This to me is part of fundamental investing. Your man has a view on health care stocks. Now that sounds to me like a reasonable, defensible view. I'm not telling you I agree, but the markets need people to be taking such views after doing some research, and that's who does price discovery. And today, while indexes are certainly a growing, successful industry, there's another industry that is growing more rapidly and it is arguably doing better, for which low fees are not the hallmark. Of course, I refer to the hedge fund industry. And obviously, somebody out there believes somebody can beat the market because they're paying two and 20, and in some cases more. And rich people are bragging that they've managed to get into a hedge fund. One of your problems is that it's not very hard for me to buy a Vanguard fund, and I can't interest my neighbors by telling them that I got into Vanguard, you know? But boy, when I tell I got into some hedge funds and I spent five minutes with the manager … that might impress them. And that is one of the big fads of our era.

Wiandt: I mean, how many hedge funds are there? Ten thousand hedge funds, and they're all going after the same arbitrage opportunities? So at a certain point you would think that whatever gains they had in those strategies would have gotten priced out by all that activity.

If you can believe it, we are actually toward the end of the panel here. But we have about 15 minutes for questions from the audience.

Question from the audience: Index funds operate best when they represent asset categories or asset designations that have markets. Some new asset classes don't have markets. Where do we go from there in terms of how to incorporate index funds that don't represent new asset classes?

Shiller: The first thing we have to realize is that while financial markets have made immense progress, we're less than halfway there. Consumption correlation across countries is very low; lower than income correlations. That means that risk management is not effective yet, because if we were effectively managing risk, our consumption would all go up and down together … we'd all be exposed only to the market. But we're all doing different things, so we're not there yet.

I think we have a whole variety of risks that we have to measure better and create markets for. Real estate is one of them. But anything that impinges on individuals and their economic welfare deserves a market. This has nothing to do with the issues that we were focusing on; this is about creating opportunities to hedge and also to invest. Ultimately, people insure each other; this is the finance theory that we talked about: that I have a risk, you don't have it, so we trade, right? I give you some of my risk, you give me something else, we're both better off. And I see this as something that will develop immensely in coming decades.

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