Are Index Funds Eating the World?
blogs.wsj.com
blogs.wsj.com
So siphoning money away to index funds does put a direct crimp on active managed fund managers' compensation.
I've always wondered why they aren't paid a percentage of profits? That would align their interests with the customers'.
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"Hedge funds as a percent of total: 1.1%"
It would be funny if it wasn't so incredibly blatant.
I barely know anything about trading, and nonetheless this is absolutely glorious. It's grown into a subculture that rivals any subreddit, with its own set of memes, photoshops, even animations. And to listen to the ever-bullish narrator, there's no end in sight to the ramp...
I'm weary of reading this on Hacker News. Index funds do not beat hedge funds. That statement is devoid of nuance and accuracy, and contributes to a narrative that active managers do not have a skillset or function.
Most hedge funds do not maintain performance that beats the market, but many do. This is easily verifiable.
Yes, it's easily verifiable. It's also completely meaningless without a rational way to predict which ones will be outperforming in the future.
Past performance does not necessarily indicate future performance, and it should not be the only predictor, but to dismiss a fund's history as inconsequential to its future is silly.
A fund's prior performance is a useful signal that can be rationally incorporated into a risk versus reward decision process.
I'm not dismissing it unconditionally, but I'm not going to believe it unless I see the data. What's the probability of a fund outperforming given it has outperformed the year before?
No, it isn't and all the funds explicitly warn you that you shouldn't do it.
The point is, funds perfomance is just a bad case of "survivor bias". Many funds are created, most of them tank and you never hear about them again, but few get lucky, make some remarkable return and get their 5 minutes of fame.
There is also one more problem with the "successfull" funds:
let's say that some fund manager actually has a secret strategy that works. At the begining, he or she just takes some initial money from investors and invest it in whatever the secret strategy suggests.
Unfortunately as soon as fund becomes popular, and people start putting more and more money in it the strategy gets thrown through the window. Why? because if you put your money in a fund that fund MUST use your money to buy stocks. Even if manager thinks that this is a bad time for buying.
Therefore, as soon as fund becomes popular it stops being strategy-based and becomes "bubble based" :)
On a related note, Buffet vs. Protege Partners: http://longbets.org/362/
Are you more comfortable with that statement?
Also, here's another one to ponder: It may be just as hard to pick a fund manager who will outperform his/her peers as it is to pick a stock that will outperform its peers. For this reason alone, I index almost all my money.
It's always funny/concerning when people who make money by taking advantage of others by leveraging their lack of education then start acting as though fixes to that imbalance are afronts to their earned/deserved position.
Although, when any industry changes, those that stand to lose always put up a fight. Everyone thinks everything they have is deserved or owed to them.
>Because corporations know that, says Prof. Heemskerk, coziness and complacency may arise. “If you have only long-term investors, how do you keep management on their toes?” he asks. “Where are the checks and balances when you have such large block holdings?”
The whole system depends on the fact that investors have an interest in voting for a competent board and are willing to sell their shares if the company doesn't seem to be managed well. If the actual owners of the company aren't paying attention the opportunities for self-dealing and just plain incompetence on the part of company officers multiply.
http://www.mymoneyblog.com/how-to-minimize-investment-return...
It is essentially a thought experiment about what would happen if everyone switched to one big index fund.
But, it glosses over the issue of individual security pricing and corporate management, which would become issues in a 100% pure index environment.
Of course, we won't ever get a 100% pure index environment, because the closer you approach it, the more incentive there is for active managers to exist.
I think what is really happening is that as more people use indexing, the less talented active managers are driven out of business. A small number of very talented active managers may eventually find themselves in a highly competitive market to exploit pricing inefficiencies, and they will end up incidentally providing management oversight and marginal pricing services to the indexers. These active managers will probably look more and more like private equity firms (taking an active hand in management), and less and less like traditional arms-length traders.
As long as this small number of talented firms isn't allowed to collude with each other, or self-deal unethically by controlling management, everything should be fine. In fact, having met some less talented active traders in person, I suspect that the quality of marginal pricing and managerial oversight may go _up_ as the number of active managers decreases, and the less informed and talented among them are eliminated.
... and I've got a bridge to sell you.
More seriously though, the smaller the number of players, the more likely (and easy) collusion becomes. Successful cartels always have relatively few players.
But that's not what a lot of index investors do. Indexers enjoy adding tilts to their portfolios. So some people will buy value funds, others will buy small cap funds, and yet others will buy small value funds. There are people who overweight certain sectors, like REITs or utilities. There are those who invest in international index funds (with all their variations) and those who don't. So there's a huge number of combinations you can think of when it comes to indexing.
Now, with people indexing like that, there would still be market liquidity. Maybe not as much as when there are single stocks being actively traded, but on any given day there will be people buying into different indexes, selling shares, or rebalancing.
Valuation would become troublesome though, but at least people would still get some return from dividends.
Plus everyone knows the S&P is a terrible benchmark because it excludes mid- and small-cap cos.
After watching mine from a far for ~7 years, I've come to accept that one really needs to invest in multiple index funds to get global diversification as well.
Such a terrible fund that it is what almost everyone bases their performance off of.
http://www.cnbc.com/2016/02/16/warren-buffett-slips-but-stil...
> His horse in the race, the Vanguard 500 Index Fund Admiral Shares, which tracks the benchmark S&P 500 index, is up 65.7 percent. That's well ahead of the 21.9 percent average gain for the unnamed five funds of hedge funds chosen by Protege Partners, a New York City money management firm.
So not just an average of hedge funds, but ones specifically selected to out perform by a multi-billion dollar management firm.
I do agree with you that almost no professional can beat the S&P 500, but I think that is due to a variety of factors, including but not limited to the outright difficulty. For example, if you beat the market consistently you still might not become rich. With $100k in starting capital, "merely" beating the S&P 500 by a few percentage points each year (let's say 10% average annual return instead of 7%) will not make you rich in the conventional sense of the word. This prevents many people with the aptitude from investing in the skill development because they could earn a greater living doing other things.
A trader whose insight is primarily responsible for driving that same return on $2B in assets is already very rich or will very quickly become so. Beating the market with that kind of capital requires an entire infrastructure devoted to trading and execution just to make the trades with minimal market movement and signalling, let alone maintaining alpha on it. Not all people capable of beating the market can do so in a manner that is actually worth their own time, because the scale can be astronomically different.
Gazing back into the history of thousands of funds to find a few funds who have beaten the S&P 500 over 25 years is interesting, but is far a guarantee that those funds will beat going forward.
The criteria for inclusion in the CRSP index specify "a minimum total market capitalization of more than $10 million with a float that more than 10 percent of the total shares outstanding". So there is sub-micro stuff 'beneath' the index that's not included due to the $10M minimum, and others that aren't included because of the float requirement. Do you care? Probably not, but you might.
Also, I've periodically heard arguments against market-cap weighting, which is what indexes do (this is probably one of those "downsides of indexing" arguments). If you are not careful, with a couple of index funds you can end up really exposed to a handful of very large, and therefore highly-weighted, blue chips. But I can't think of another way of weighting within a whole-market index that would make sense.
The other thing that comes up a lot, mostly in tech circles, is that index funds (of course) don't give you exposure to the private market, and it seems that more and more tech companies are waiting a long time until they go public, such that at any given time a lot of growth is happening where most investors can't get in on it. The argument is that, if you are financially qualified, there are more opportunities out there for qualified/accredited investors on the private market. I don't personally agree with this if you're looking for an investment rather than a job as an investor, but you'll sometimes hear the argument get made.
If the total market is outperforming S&P 500, that means the companies not in S&P 500 perform better overall, so giving them greater weight than suggested by their relative market cap would have been beneficial.
[1]: https://www.amazon.com/Invest-Like-Pro-10-Day-Investing-eboo...
You could do a lot worse than parking it in an index fund, so yeah, that's a good approach :) If you have a 401(k) or other retirement account, it is quite common for those to offer an S&P 500 index fund where you could invest your money. If you want to do it in a taxable brokerage account, you should open an account with Vanguard and buy their Total Stock Market index fund (VTSMX, or VTSAX if you have more than $10,000 to invest).
Then stay the course - if the market tanks 50% the day after you put your money in, don't panic. Wait it out. Your investment horizon here is at the very least 10 years.
But that's the quick, the-best-time-to-invest-is-tomorrow-so-just-do-it answer.
There are a number of things you should do if you want to learn more about how to invest your money in stocks (and maybe bonds):
0) A good resource to get started quickly is If You Can, by William Bernstein:
https://smile.amazon.com/If-You-Can-Millennials-Slowly-ebook...
But you can skip it if you want to dive deeper with the stuff that follows.
1) Learn about what investing in the stock market means, what's the nature of it and what to expect from it. I have two recommendations here:
1.1) jlcollinsnh's Stock Series: http://jlcollinsnh.com/stock-series/ He recently released a book (The Simple Path to Wealth) which is supposedly a better-edited version of the Stock Series. He's a rather optimistic guy, but what he says is not wrong. He stays away from investing in non-US markets, which is not the most common position among indexers.
1.2) A Random Walk Down Wall Street, by Burton Malkiel. It's an amazing book that everyone should read if they want to learn about the stock market. Many people recommend Bogle's books (he's the father of index investing), but I find them incredibly tedious to read.
2) Learn about the different investment accounts available to you - 401(k)/403(b)/457(b)s, IRAs, HSAs, taxable brokerage accounts. Each one receives different tax treatment and you should be familiar with that in order to avoid "tax drag" i.e. taxes slowing down the growth of your investments.
3) Another resource I highly recommend is the Bogleheads wiki: https://www.bogleheads.org/wiki/Main_Page. In particular, check out the following pages:
https://www.bogleheads.org/wiki/Bogleheads%C2%AE_investing_s...
https://www.bogleheads.org/wiki/Three-fund_portfolio
https://www.bogleheads.org/wiki/Tax-efficient_fund_placement
4) Don't obsess about it once you get started. After you've learned a few things it's tempting to start "tweaking" your investments here and there, but if you do that often you do yourself more harm than good. Invest your money then go have some fun :)
So index funds are not eating the world.
Most Wall Street traders underperform the market. Even the hedge fund crowd mostly underperforms the market. "A Random Walk Down Wall Street" is real.
So, the real question is what percentage of funds are index funds.
Vanguard owning 6% of the entire US stock market value is huge. You could reasonably re-title this "Is Vanguard Eating the World" and be right if it wasn't for Blackrock and other ETF firms being close behind them.
Sources: https://finance.yahoo.com/quote/AAPL/holders?p=AAPL and similar pages.
It's a real book, but it doesn't prove the market is random, nothing does as the efficient market hypothesis is just that, an unproven hypothesis lacking even enough evidence to become a working theory.
That certain funds consistently beat the market year in and year out for decades is enough to disprove the notion that markets are random; they're not.
When so many people are playing, there's bound to be some that consistently win, just by chance alone. The book discusses this.
That markets are random is a hypothesis only; one lacking sufficient evidence to declare it a theory.
No one has proven markets are random and that's where the burden of proof lies.
Besides, even that is "only" a one in a million chance. How many people trade on the stock market?
By the way, which funds have beaten the market for decades?
Jim Simmons doesn't agree, see Renaissance Technologies as an example. And time would week out lucky winners; luck isn't consistent over long time periods and this is just one example.
edit: heh, snap.
Are you saying the above won't happen?
Lots of money and market push there as indexes.
Bogle said that there could be issues at the 90% level, so we are still pretty far away.
My issue is funds that are Index 500 or DJI average are set by someone else. Hence the huge number of funds that own Apple and can push on them. When they rebalances those indexes, it can be a traumatic event.
On the other hand, index funds are a way of playing par golf with your money every day.
The situation described is clearly not a Nash equilibrium. If you have special, accurate information on the price of a security, then you're going to act on it. Why would no one be doing the work of pricing something if it's profitable? Sounds like actively managed mutual funds are getting antsy because people are starting to realize that they're getting screwed not going with index funds.
All companies converge on the same P/E ratio, and the ratio of the index depends on how much investor money is chasing the overall productive activity of every [investable] company in the economy.
It wouldn't be the end of the world, by far.
But it is doubtful this will ever get even close to happening, because some investors will always be gamblers at heart, and if they learn that Coca-Cola is releasing a new beverage flavor, they will use the financial markets to make bets on whether it will be insanely popular or a colossal failure.
If a company can reinvest earnings at a high rate of return, it's to the advantage of stockholders if it doesn't pay dividends. How much should the index weight it?
If there is no market trade price for a stock, the only way investors can realize value from owning shares is through dividends. Increasing the value of the company does nothing for the owners individually if shares for a specific company have no individually identifiable price. Everybody is buying and selling through the automated index funds, remember? The only way to get higher capitalization in the opinion of the fund robots is to issue better dividends. There's no one to sell to at a higher price, except the other robots, who all have similar valuation algorithms, and will need to sell the same amount as your fund robot in order to realize any gains.
But that is all absurd and moot, because there will always be a price, as long as two individuals are willing to move differently from the herd. As we are mostly humans in our market, that behavior is practically guaranteed. The outlier who thinks the stock is outperforming the whole market will buy from the outlier who thinks that the stock is underperforming. And their combined beliefs and opinions will create a price for it.
Ergo, index funds are not eating the world.
The fewer people there are that are willing to try to beat the funds or game their algorithms, the easier it will be for any one of them to succeed. So there will always be at least one.
First that comes to mind: small caps historically get better returns, and maybe that difference will be amplified by market-cap-weighted funds.
Picking stocks which are growing but not quite big enough to get into larger cap indexes could be another possibility.
By the economist's reasoning, someone already has a strategy to take advantage of index funds. Actually, a lot of someones already have every possible strategy to take advantage of index funds. So none of them really make significant returns, because the dead whale is eaten by a million scuttling isopods, each taking one or two bites before it's all gone. So the real money is in taking advantage of those guys, perhaps with fees or paid reports or little boxes that light up and go "ping".
Of course, just because all the free money is already being picked up, doesn't mean you will never catch a flying $20 bill if you decide to make a grab for it. No market is perfect, and there's always an opportunity to grab some free money somewhere.
That being said, I fully believe there will always be active investors. As others have mentioned, if there is an opportunity to make money in the market due to something like passive index funds being slower on the uptake, it will be made.
If I had to interpret the core argument being made here, it is basically that there is a fear of a positive feedback type scenario where money keeps getting dumped into companies simply because it always has. But it can be highly profitable to beat out the slow, passive money by doing your due diligence. For this reason, active management will always exist.
Also, I am fortunate enough to work on some of the more complex and interesting products in the industry (at least I believe so, haha). I can tell you that there are definitely sanity checks put in place for this kind of scenario. Most of it revolves around fundamental ratios built into these product methodologies (i.e. P/E ratio must be within a rational range, company must produce stable income for the past 5 years, etc.). More importantly, securities in these portfolios are frequently weighted (at least in part) upon those fundamental ratios. So if a company starts to deteriorate, the size of the position in the fund will be decreased. Much of what the article talks about seems to be negated by this and becomes a non-issue. I think those arguments would apply more to benchmark products which don't have those kinds of requirements. Then again, many benchmarks are used for exactly that - benchmarking - and aren't directly invested in. There are, of course, indices like the S&P 500 that have significant sums of money attached to them, but they are the exception, not the rule. Most index products deemed "investment-grade" are STRATEGY based, not benchmark based.
Basically, there is room in the market for both. I think we are simply seeing the progression towards a new equilibrium, nothing more. That equilibrium is where the new balance of those willing to take a higher risk meet those that want the less risky, low cost products that we provide. There is simply a much smaller portion of the population willing to pay higher fees and have a larger risk (but with possibly greater reward). And that is due in part to the fact that many money managers don't have the returns to keep people coming back. It's also due in part to people's mistrust of the market (and financial industry in general). They are simply allocating their money in accordance with their risk appetite.
http://www.wilmottwiki.com/wiki/index.php?title=Grossman-Sti...
There may be fewer active investors than before, but that doesn't mean the market won't function.
This situation will be easy to spot from indicators like P/E ratio. P/E limited index funds will be new hotness and active investors should get better returns.
There is bigger problem than index funds and it's closet indexing. Many portfolio managers that claim to be active investors secretly follow their benchmark index without exactly replicating it. This is fraudulent behavior.
As long as they can also provide competitive maintenance fees and tracking errors don't play against them, I don't see much of a problem. If they consitently do worse than the ETFs based on the same indexes with a similar risk profile, the market will eventually punish them for under-delivering.
If they only make a few picks that end up doing well, keeping the rest of the benchmark for a balanced risk profile seems sensible to me.
Please explain where the problem lies exactly?
The problem is with consistency and eventually. Definition of closet indexing is active share below 60%. These funds are not consistently worse if the observed period is just few years.
Since actively-managed funds usually perform worse than index funds in long term, closet indexing should be able to keep up with actively managed fund with same costs.
Selling funds is mostly marketing. Asset management firms have several funds and they sell the one that randomly performs better than it's benchmark in some short period of time (1-3 years). Very badly performing funds are merged into other funds and new funds are created.
Research shows that 15-20% of European large-cap funds could be labeled as closet indexers and 15% of the net assets in equity mutual funds sold in the United States are closet indexers.
And that's a terrible investment strategy to ask of the average layman, the people who are concentrating on index investing.
We've a ways to go before the pendulum has swung enough in that direction. I'm more concerned about the tendency to seek short-term profits at the expensive of long-term investment in today's Wall Street CEOs.
That's a pretty hypothetical scenario, isn't it? Index funds, ETFs in particular, are a brilliant idea that allows ordinary people to participate in the success of market trailblazers.
If it wasn't for index funds most people wouldn't be able to make reasonable investment decisions because they're not investment bankers who deal with that sort of business on a daily basis. Even investment bankers fail with their investments most of the time. It's usually just the few successful investments or things like arbitrage that balance out the odds.
Ordinary people usually neither have the knowledge nor the resources to do investments this way, so index funds probably are the best option for accumulating wealth over a period of time.
In which case the actively managed funds which identify the mispriced assets would start making money and attract investors again. You know there's trouble brewing in the industry when mutual funds are trying to sell investors on "it's good for the economy!"
I'm surprised the author omitted it, but can anyone comment whether this is different for robo investors (Wealthfront, Betterment) vs a traditional index fund like Vanguard?
They give you the canned advice that your local Financial advisor gives you, minus the quarterly meeting and phone therapy when the market goes down, and plus some automated intelligent handling of capital gains to reduce your tax exposure.
good Lord
If there is a real contraction in the health care sector and people react by pulling out of the market entirely then that is a good thing for people looking to put money into the market; the rest of the market is on sale (relative to its "real" value). Even if the market is made up entirely of indices, the market as a whole will end up appropriately priced. Those who panic sell will lose money but the index will bounce back assuming non-health care assets truly were undervalued.
Is there any reason an "active" manager cannot behave like a passive manager? Is index investing just outsourcing the stock picking?
10 years ago, everyone wanted to be in the hedge fund industry. Today, it's tech startups. Having worked in both fields, you encounter the same folks running from funds to startups.
Hedge fund fees probably move to 1 and 10 over the coming decade, but active investing and price discovery are very valuable. For those willing to do the work, small and midcaps still can generate alpha. However, it will require spending many hours traveling and meeting with management and being engaged in the sector virtually nonstop (trade shows, conferences, reading articles/news).
I think generalist active investing will go away, but sector focused active investing will remain.
Could, he says. lol.
-- Betteridge's law
"serfdom", "Marxism"... Let me guess: Libertarian Party propagandist.
Or just someone who is well-read and likes to throw in literary references.
> Or just someone who is well-read and likes to throw in literary references.
~libertarian here: don't know him, but I'd bet he is what op thinks
With passive investing you invest in a stock because you think the company's value will grow in the future. They are building a new factory or entering a new market, etc... The added value will be represented by a higher stock price which you can sell to obtain your investment returns.
>The social function of active management, in a capitalist society, is that it seeks to direct capital to its most productive end, facilitating sustainable job creation and a rise in the aggregate standard of living.
What if an actively managed fund gives me a 10% return but a 4% fee and a passively managed fund gives me a 8% return but only a 1% fee? Wouldn't the passively managed fund be the most productive from the investors point of view?