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Comment by StavrosK | Hacker News Reader

I've recently heard doubts that index funds are a good investment. They're meant to be "investing in the US market", but aren't they really "investing in the Vanguard/whatever ETF"?

Basically, doesn't the value of index funds reflect how much people think index funds will rise in value?

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Index fund prices are tied to an index, hence the name. If the DOW goes up for a DOW index fund that fund will increase in value proportionally. Vanguard gets paid for managing the fund.

Ah, so the value of an ETF isn't what someone else is willing to pay for it, like a stock?

EDIT: Apparently you can exchange the ETF for the underlying securities at any point, and vice versa, so the ETF's price can't diverge much.

It's not so much that you can exchange a share of an ETF for micro-shares of the underlying security, but that the ETFs themselves keep their assets in the underlying and if it gets out of balance professional investors will short one side and go long the other and make the difference -- a form of arbitrage.

Specifically, in the case of SPY, if the ETF was trading higher than the underlying, they would short the ETF and go long an appropriate number of shares of each of the 500 companies. The difference in the price is their profit. The very act of doing this brings the two prices inline and eventually you sell both sides and close the position for realized gains.

Brokers let you do these transactions atomically. Of course, for transaction fees alone, this is not a strategy available to retail investors.

This is correct; Authorized Participants are the ones who exchange baskets of securities. It isn't really possible for individuals to exchange shares directly with the fund manager, but that's not an issue because the secondary market prices are kept reasonably close due to the professionals. The amount you can expect to lose relative to NAV (the actual value of your shares) is around half the bid-ask spread at the time you buy/sell.

It also helps with tax efficiency since the creation/redemption process allows for shares with significant appreciation to be retired.

I see, thank you for the clarification.

Not really the ETFs are generally backed by the actual securities they represent. They may deviate from market value a bit intraday, but those deviations are picked up by special arbitrageurs and quickly eliminated.

http://www.understandetfs.org/creation_redemption.html

Ah I see, thanks, I wasn't aware of that mechanism. So you can basically exchange the ETF for the actual held securities at any point, which keeps the price near that of the securities, pretty clever.

The thought is that with index funds, you're invested in enough of the market that you don't have to pick winners and losers and you get rebalanced as well.

It would be interesting to study the market cap effect of going from #501 to #500 in the S&P ratings.

If you think the entire market is overbought, then they might not provide the best returns over the short term. However, most people are very bad at timing the market or picking the strongest companies that will thrive in a down market.

There S&P 500 is selected by a committee so there is no #501.

My point is that there is probably a bump going in and a hit falling out. This wikipedia article (https://en.wikipedia.org/wiki/List_of_S%26P_500_companies) shows the additions and removals. I am curious about the distortive effects of demand from the S&P 500 as a proxy for the effects of passive investing.

Technically there are 505 due to dual-share classes for 5 of the securities in the index.

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