Are Index Funds Communist?
bloomberg.com
bloomberg.com
This makes sense, the US, Canadian and most European stock markets have performed well over the past 100 years.
Here is a though experiment....
https://si.wsj.net/public/resources/images/BN-GE653_nikkei_G...
This is a chart of the Japanese stock market's returns over the past 25ish years. As you can see it's flat.
Japan stock market has been in a low interest rate, low growth regime for a long time now. You'll notice that its now back to where it was roughly in 1988.
What should people invest in when you are in a zero interest rate and zero growth stock market?
Bonds won't pay much in low interest rate environments and I'd/expect dividends to also be relatively paltry.
This is one area where I believe that active investing, specifically hedge funds, or other "smart beta" funds can be a win over passive investing. Though I might be biased.....
What other strategies can someone use in a stagnant growth and low interest rate environment?
Thoughts??
This is why people with money in the market care (or should care) a lot about GDP predictions.
Think about a truly reductionist outlook on the product of index funds: put money into this thing, with very little effort on your part, and you'll make enough money to retire on! Sounds way too good to be true, to just throw money at something and it makes you money.
One argument is that well, you're investing in the US economy (or the global economy, depending on your index fund). You're putting faith into the economy as a whole...but that means you're also blindly investing into businesses that may not (and should not) be performing well. Companies that may be lagging behind will be artificially inflated in a groupthink (or I guess groupinvest) mentality.
At a smaller level, this becomes a problem when those funds differentiate on things like market cap. If a company has a bad year and drops market cap from $2.5B to $1.8B, that means the company went from being a large cap to a mid cap company in the eyes of institutional investors. So based solely on market cap (and not fundamentals of the business), Vanguard will dump it from it's large cap funds and buy it up on it's mid cap funds. And if most people are only investing in the S&P 500 or Large Blend funds, then you're seeing a massive shift in ownership in companies solely based on one metric. How can this be sustainable for the overall economy? Warren Buffett and many successful investors have told people that you should treat a stock as owning a portion of a business. We've completely separated ourselves from that ownership (and responsibility) when we entrust our money in index funds. And when some of the largest companies are owned by some of the largest financial institutions, it seems like the companies are getting in bed with the same architects of our recent financial meltdowns.
In conclusion, something just seems off about throwing money at a fund that makes somewhat arbitrary decisions for how it owns businesses, and supports the bigger businesses while penalizing the smaller ones (via groupthink and ownership).
"...active management has positive externalities, and if no one will pay for it, those benefits will disappear."
It probably contributes to poor corporate governance. The more your shareholders don't even bother to vote their proxies or even think or read about them, the easier it is for management to gradually evolve into caring more about padding their position and making short term results look good than catering to long term shareholders
It's a bit of a free-rider problem -- as long as there's enough active shareholders, passive shareholders can get a free ride and profit from the (averaged) wisdom of the active ones without paying for it in time/effort. But if that keeps growing, eventually the active shareholders who care are a minority in the company, and at that point management is incentivized to ignore the minority that cares and just "appease Wall Street", ie do whatever gives short term stock boosts.
> And if most people are only investing in the S&P 500 or Large Blend funds
BTW, IIRC, the largest firms are so large that most of the market by market cap consists of the largest few, so investing in just large cap vs investing in the total market is close to the same -- you have to manually skew towards medium and small if you don't want them to be negligible in your portfolio.
Therefore, the investments to look into are those in which capital is just part of the package and where some other economic factor (eg land, labor, ideas and risk taking) is a critical part of the value added. No guarantee they'll do better or you'll find anything, but I believe that's where you could look and actually have a chance of finding something.
E.g., real estate, small business, etc. Those things are also generally traded on relatively inefficient illiquid markets, which is also great -- the averages apply a lot less then. By analogy, if you're looking to get into the business of finding $20 bills on the ground, you might want to focus on poorly-lit areas, because someone else will probably grab the ones in the well-lit areas. In low interest rate times, efficient markets like securities are traded on suck. The fewer people can realistically participate in evaluating the value of and/or trading in a given asset within an asset class, the better.
Just my unprofessional hobbyist opinion though, would love to hear any disagreement or other thoughts! I'm not currently practicing what I preach (can't afford to yet) but by the time I can this is the direction I'm thinking of exploring in, rather than investing more than a token amount in securities. As you say, the interest rate environment has gotten so abyssmal it no longer feels like there's much point.
As usual, scarce, durable things. Houses, land, gold, bitcoin.
Apparently printing of new stock in Japan is in line with the need for it. I don't see why it shouldn't be this way.
IIRC, one of the theories is that Japan's banking system allows zombie companies that should have been declared failed businesses to survive. In that situation, there's really nothing left to constrain management from rolling the dice on high risk low reward strategies, or worse, not changing the strategy that led them into secret bankruptcy.
So to the extent that the Nikkei continues to hold zombie businesses, or the banks that prop them up, it's not a good passive investing benchmark. Which means active investing has a role in filtering them out.
Index funds are capitalist: cut out some of the lazy middle men (who doesn't care whether you win or lose, as long as he gets his cut) and lower the management fee.
Eliminating useless moochers is just as capitalist as it is communist. (All that differs is how "moocher" is defined, and whether force is used, or market choice).
Fund managers playing the market with borrowed money might be in jeopardy though.
Looking at a macro/whole economy level, the only capital allocation questions are how to price an IPO or secondary offering, what to do with distributions, and corporate governance. Everything else is just moving money from one pocket to another, and once a company has gotten to S&P 500 size, there aren't very many secondary offerings. It seems highly unreasonable to me (and all of the other index investors) that this function is worth 1% of the market cap of all public companies, every single year, particularly when E/P ratios are 4%. That means your fund manager is taking 25% of the profits of all of the companies you own just for picking which ones to buy.
In the places where there are real decisions to be made, i.e. IPOs and governance, there are specialist companies that exist to make these decisions and try to profit from them -- activist investors and funds, private equity, and investment bank underwriters.