Index Investing Makes Markets and Economies More Efficient (2016)
philosophicaleconomics.com
philosophicaleconomics.com
There will be an inflection point where stocks in indexes are so overvalued that enough active investors (and passive defectors) cause a rebalancing. If they're overvalued enough, and enough of the general market participates in them, index funds could easily crash.
Apps like Robinhood are making active investing much more feasible for your average Main Street person. I certainly am not counting on the continued blind investment in index funds.
This presumes that the only reason stocks are in the index is because of index investors, which is not the case.
There is only individual intelligence, which can act with other individuals. That is, there are only individual investors - actors - whether we're talking about retail or hedge funds or even AI bots. There's no seven million headed investor automagically sharing a brain and its accumulated wisdom. The point being, each investor that is acting on the market, is acting from different conclusions (even off of exactly the same data), with different intent, and with different capability of deduction and discipline and implementation and so on.
Most of the professional investors that manage money for others are not very good at generating returns. They tend to be horrible at taking advantage of the vast market inefficiencies that made Warren Buffett and dozens of other famous examples possible. To make matters much worse, said mediocre professional investors then make their money by skimming off the capital they manage. When that's your scenario, index investing will always make sense. The only time it doesn't, is if you possess numerous rare attributes that make it possible to take advantage of the inefficient market, or if you can find a rare someone to trust your money to that can do so.
How does one find market inefficiencies? Elon Musk's First Principles analysis is one thing that comes to mind.
In an index the goal is to buy everything of a kind: all of the stocks in the S&P500 or all of the stocks listed on the NASDAQ. A handful of people aren't arbitrarily deciding which of the 500 biggest companies are.
The goal of the index investor is to get average performance - active traders can worry about the microeconomics. If too many people index invest then there will be huge market inefficiencies for active traders to make money on, which will attract more traders to the market, which will make the market more efficient.
Right...
https://www.cnbc.com/amp/2017/08/01/sp-500-to-exclude-snap-a...
Edit: note that Fortune 500 and the S&P 500 are not the same list.
As in: you select the stocks and their proportion and supply the money/demand money out, and stocks are then bought/sold automatically?
Say I want to follow index X, but I don't want stocks in oil or coal companies because I believe they're going to die before I need the money out. There doesn't seem to me to be an easy way to build that customized index.
I guess you need a low-fee stock broker and an algorithm that's aware of the fees for this to not end up drowning in fees.
Have fun,
Not great for research, but functional to buy/sell.
Edit: I see a $110M Series C in April '17 reported for Robinhood.
When you buy and sell shares in the "real" market, you do so in whole numbers. If you're going to construct an index fund just for you, the smallest amount of any stock you can buy is 1, so you'd need an enormous capital investment: if you want e.g. 1% of your fund to be Google (currently trading at $934), and assuming all the share prices work out just right -- in practice, they won't -- your smallest unit of investment would be $93,400.
In practice, the closest approximation of what you describe is just having a passive portfolio: pick a bunch of stocks, buy them, and then don't look at them again.
Basically, you determine the dollar amount you want to spend on each stock, and the plan purchases that amount, including fractional shares.
I don't think they do the same for selling.
http://www.sectorspdr.com/sectorspdr/
So, you can either:
1) Buy all the sector ETFs (XLY, XLP, XLF, XLV, XLI, XLB, XLRE, XLK, XLU) except for the energy sector (XLE)
2) Buy the SPY, short sell XLE.
Different tickers apply for iShares, or other indicies / sectors, but you get the idea - it's easy enough to focus on specific sectors using a mixture of ETFs.
People invest in an IPO in the first place because of the promise of liquidity down the line.
If investors were told that they couldn't freely buy or sell shares after the first time it is sold, the IPO is going to do far worse.
The ability to trade the stock around directly helps the company by making the IPO more successful.
That's not even considering that the company could issue secondary offerings.
They didn't anticipate _your individual_ actions, but it's highly likely that the persons that bought into Facebook's IPO did expect that they would be able to sell the stock to _someone_ at a later date.
So, yes, people anticipated your actions now (if you look at _your_ actions as the general actions of the crowd, instead of your individual actions)
By buying Facebook stock now, you're fulfilling that expectation of earlier investors, which motivated them to provide Facebook's initial funds.
Liquidity along with higher prices along with improved business metrics, which provide perception and confidence to the market to promote higher prices, are used by the business to obtain cheaper financing and the employees of the business to also obtain access to credit based on their holdings of the stock.
These are colloquially called resources to businesses.
I just don't follow the reasoning that stock price enables resource allocation.
Companies can issue bonds if they want to raise large amounts of capital. Those are traded on a different market and are fundamentally different than stocks. They are debt instruments, not ownership.
Post-IPO, companies can also raise additional capital by issuing more shares (either to the public or by e.g. issuing RSUs to employees). Only in those cases is the stock price relevant. Otherwise, the market can be mispricing a stock without any bearing on the functioning of the company.
It wouldn't, because there isn't anything else they can do with the capital other than sit on it in a bank and get no return.
The myth that the stock market is relevant is put about by people who work in stock markets. Much like share buy-backs are the same as dividend payments. Exactly how giving the company's money to people who want to stop investing in the company is the same as giving it to those that do is a triumph of using dodgy maths and statistics to fool people.
Also of note index funds do have feedback loops as they try to retain a balanced portfolio. If company A is worth 1 billion and company B is worth 2 billion yet they have equal dollar investments in both, then they sell some of A to buy some of B. This greatly magnifies the impact of active traders in a 99% ownership situation.
> If company A is worth 1 billion and company B is worth 2 billion yet they have equal investments in both, then they sell some of A to buy some of B.
This is a paradox -- both of these are examples of market movements which require the percentage of stocks held outside of index funds be equal to or greater than the volume required for the price movement. The critical point is much lower, and as more people buy into index funds, the active traders make more money rebalancing and therefore are able to increase their own positions, providing negative feedback and preventing the index fund ownership from rising more. I don't know what the asymptote is, but I suspect it's closer to or equal to 50%.
Another way to think of it is that markets would be incredibly illiquid with 99% index fund ownership -- that's not much ownership for market makers, but their profits would be tremendous due to the thin order books, driving in more market makers and thereby increasing their market share until it's no longer easy money.
My point about ownership percentage was simply that passive traders and active traders only interact when the total amount of stock changes. But, passive traders are simply speeking a fixed ownership percentage which means they don't change the final price only the active traders who must end up with that same 1% based on price movements.
If they own 1M$ of A and 1M$ of B, but B is worth more than A then they sell some of A to buy some of B.
Keep in mind that this doesn't (at least not naïvely) happen when one of the two increases or decreases in value relative to the other.
For me, the most interesting observation in the article is that poor active returns are a sign of market efficiency.
[1] http://www.marketwatch.com/story/john-bogle-has-a-warning-fo...
I think a way to look at it is what earnings multiples companies trade at signals to companies how much money they can raise in an IPO or follow on equity issues.
For example, if Boeing is trading at 5X EBITDA then it signals to other aerospace and defense companies that they can expect to raise capital at a similar multiple.
It's indirect, but it still provides a service: creating a predictable, liquid securities market which firms can use to raise capital.
The business actually has little need to get involved at all in its stock market listing if it is just getting on with its business.
It's only when you start using shares as currency to buy other things (whether manpower or other companies) that secondary listings and the ability to swap them into cash starts to matter.
There's a fairly reasonably argument that a stock market in its modern construction is actually more of a hindrance to genuine equity investment and it shouldn't exist. Then those investing in equity have to look at the ability of the company to generate an income rather than sell itself to the greater fool.
This is unlikely to be a popular opinion amongst passive investors, but day traders and market makers are responsible for making economies for efficient and providing price discovery (if they make profits) by reducing the spread and reducing volatility. Traders who lose money have the opposite effect -- they make assets more volatile by pushing up tops and pushing down bottoms.
Active long term value investors also contribute to positive price discovery and reduce volatility (if they make money) for the same reasons, but on a different time scale.
Price discovery of a price that's only useful to other baseball card collectors^H^H^H^H^H^H sorry, market traders.
I'm not surprised everybody is missing the biggest advantage of index investing: it gets you a diverse collection of income-producing assets.
This isn't about whether index investing is a good strategy for many people, especially those with low-moderate risk appetites and no time/expertise for active investing or trading.
It's about whether or not index investing makes markets and economies more efficient (which the article erroneously claims). I claim they have the opposite effect, but they create value in and of themselves that counteracts that distortion to the benefit of index fund users (and to the benefit of traders who arbitrage the distortion).
Now, if the passive investment flow comes to dominate volume on any given day, then the "marginal" trade becomes a passive, uninformative one; then we have a problem.
I'm just saying that index funds do not make markets and economies more efficient, as the article claims, so if we had a 99% ownership tied up in index funds scenario, markets would indeed be far less liquid and more volatile.
Stocks in the passive investment category stay that way forever- they are never sold at any price.
Money never enters or leaves the stock market
Companies never issue or buy back stock.
I mean with bat crazy assumptions like these, you can come up with any conclusions you want!
HOWEVER, that doesn't necessarily mean the growth of index investing makes markets more accurate at pricing securities.
There's NO evidence of that.
Maybe the growth of index investing is doing the opposite: making markets LESS ACCURATE at pricing securities.
Indeed, by many measures, US stock prices are looking positively FROTHY these days.[1][2][3]
[1] https://www.nytimes.com/2017/09/15/business/stock-market-mas...
[2] https://www.nytimes.com/2017/06/29/business/stock-market-val...
[3] http://time.com/money/4943479/wall-street-prediction-stock-m...
The more accurate a market is at pricing securities, the less severe the magnitude of bubbles and subsequent crashes. Bubbles are extreme examples of overoptimistic pricing.
To be clear, I do NOT know if index funds are causing pricing to be less, or more, accurate. I don't think anyone else knows either.
That said, it seems to me that (1) the ongoing mass-scale removal of intelligence from the investment process is unlikely to make pricing more accurate, and (2) these days, stock prices are looking frothy by many measures (e.g., Shiller CAPE).
To put it another way: the actual value of a no-dividend no-vote stock is precisely zero. The price is whatever the buyer and seller agree on, right? So how can one price be more "accurate" than another?
That right is the ultimate determinant of the value of a no-dividend no-vote stock: fractional ownership of the right to proceeds in the event of liquidation, after those above have had theirs.
As a higher-risk asset, it produces greater returns, since otherwise there is an arbitrage: buy bonds issued by the same company instead. This arbitrage lasts until the bond becomes "expensive", and therefore produces worse returns (since its payout is independent of its price).
Now, in the real world, there are several significant reasons why that model model offers nothing but a fun little thought experiment.
"The aggregate performance of the active segment of a market will always equal the aggregate performance of the passive segment." (before frictions like trading costs and taxes are taken out.)
I hope those economists have a more sound basis for this claim than the author gives here - assuming, of course, that the author of this article is not misrepresenting or misinterpreting them. To take an extreme case, if all the passive investment is in a single asset, I don't see how this could be, and an issue with passive index investing is that it is in a limited set of assets.
http://www.frmocorp.com/indexation.html
In principle, the theory behind indexation is very much like the theory of perfect competition. In perfect competition, the idea is that no participant is sufficiently powerful or sufficiently large to influence the price of the product. The product is assumed to be homogeneous, and shares are designed to be homogeneous. In the theory of market efficiency, no one has an information advantage over anyone else, and there is always enough liquidity. It seems reasonable to make those assumptions. Yet, it is worth making some observations about them.
Also, what bothers me about indexing, is that a lot of money is going into same companies(S&P500). Look at any S&P500 companies Top Institutional Holders and without a doubt Vanguard is on top(wild guess). Not sure what happens with the price, when company is excluded from S&P500.
In conclusion, indexing is fun in the bull market, it's just you can't retire in the recession years.
Piggybacking off the article's example: Suppose news breaks that Facebook has made a catastrophic legal error which will result in them losing 50% of their revenue over the next year. This is obvious to the active investors who collectively decide to sell their Facebook shares, resulting in a fall in the total value of the index equal to the drop in value for Facebook. In the time it takes the old pre-news price to drop to the new post-news price, active investors have, on net, sold Facebook and gone to cash and will have shared in a relatively small portion of the crash, and passive investors will have bought Facebook due to churn, or held Facebook as part of the index, resulting in them absorbing a larger portion of the crash than active investors.
So how does this all fit into the "active managers don't earn their keep" narrative? I think what we've seen is a long term drop in the alpha available to the active share due to things like narrowing spreads, faster response to new news, etc. So effectively active management is in a secular decline, which allows for (1) bad results for active managers on net, and (2) failure of poor performers and their removal from the market, and (3) continued real value generation by the better and remaining active managers. So this idea of conservation of alpha is also silliness because the market will always be slightly oversaturated (net negative value for money managers) or undersaturated (net positive value for money managers).
If you doubt this, read Ben Graham's the "Intelligent Investor" -- In 1949 he thought it was quite easy (EASY!) for an average Joe to earn outsized returns with a little stock research (and I think history proved him right until at least the late '70s).
That is a myth that refuses to die.
Market makers and liquidity providers enter into neutral trades so it doesn't matter which way the market goes..they make money from the spread and churn. Just because you made $40k from being long Google doesn't mean some schmuck lost $40k.
Eventually, indexing comes around to disrupt the industry. Of the 500,000 individuals that were previously managing funds, 499,500 go out of business, with their customers choosing the passive option instead. The remaining 500–which are the absolute cream of the crop–continue to compete with each other for profit, setting prices for the overall market.
Indexing has been around for a long time now, but active mgmt has had a terrible time and is actually getting worse in recent years, against the author's thesis that passive investing is supposed to create a small pool of 'superstars'.
Some schmuck sort of did. The market makers and liquidity providers are not the source of the sold stock, simply intermediaries.
"is actually getting worse in recent years, against the author's thesis that passive investing is supposed to create a small pool of 'superstars'."
This is a huge point of contention. Capital takes a long time to flow out of mutual and hedge funds which have been underperforming. It could be many years yet before any "superstars" emerge.
If they have no intrinsic value of course passive management makes sense!
This article is concerned with the average skill of investors, an entirely meaningless metric that determines nothing. The marginal investor determines prices not the mean one.