The Growing Peril of Index Funds: Too Much Tech | Hacker News Reader

The Growing Peril of Index Funds: Too Much Tech

wsj.com

93 pointsclorenzo68 comments

The second edition of Jack Bogle's "Little Book of Common Sense Investing" came out this last October. It goes into detail in evaluating active investment such as what's being recommended in this article v.s. passive investment.

Plainly put, I've yet to see any compelling evidence that the supposed experts being quoted in this article can time the market as they're suggesting with their suggestion of getting out of tech stocks now.

The percentage of active management firms that can beat the index funds even before you factor in their high fees is so miniscule that random chance could account for those low numbers.

The market's almost definitely heading for a bit of a crash in a few years, but it's instructive to look at how passive v.s. active investing did in 2008 (detailed in this book) to see how much these supposed experts really know.

Increase in passive/beta investing is not necessarily good for the economy. We are going through an extraordinary period for levered beta.

This isn't about timing the market, it's about rebalancing and maintaining a good diversity of exposure to various sectors. Rebalancing is not antithetical to passive investing.

This article is talking about diversification to reduce risk, which is unrelated to "timing the market" and which can be consistent with passive investing.

Some investors described in the article moved from market cap weighted indexes to ones that were disproportionately weighted to disfavor tech stocks, they believe that they're overvalued and that they can get out earlier than everyone else.

That's trying to time the market.

The firms mentioned in the article will be happy to charge you much higher fees than Vanguard for questionable longer term returns. It's basically a PR piece for managed investment.

Even if the average returns and risk are identical for each security individually, you can minimise your portfolio risk by investing equally across many different industries. If a downturn were to occur, different securities in a single industry will be much more correlated, as compared to different securities across different industries.

Yes, that makes sense. But that's entirely unrelated to what I'm pointing out here.

(Some of) the article is making the argument that investors should decide for themselves how over- or undervalued certain segments of the economy are.

So on one hand you'd have a diverse market cap weighted index where you buy into stocks representing the proportional to their portion of the economy.

On the other hand you might think you have special knowledge to layer on top of that. Are banks undervalued? By how much? Let's say 10%. Then let's sell something else to buy 10% more banks, now what's 10% overvalued? Tech?

I've yet to see any sort of compelling data that this sort of managed investing is a good idea, and that's what it is.

Just because you're not buying TSLA and instead just disproportionately buying "car stuff", or not selling AAPL but just selling "tech stuff" you're still trying to pick stocks and trying to beat other stockpickers doing the same thing. You're just picking subsets of the economy instead of individual stocks.

I don't think it's a good idea to guess what's over/undervalued. But equal weighting different industries is not quite the same thing. No matter how you weight things (by capitalization, by company, by industry, whatever) you are making assumptions about correlations. No dogma can tell you which is right a priori, because correlations change, especially in crises when it matters most.

Also...the total market, cap weighted, may be the optimal way to invest the whole world's capital - but that doesn't mean that it's the optimal way to invest, say, $50K. If you have $100B, say, you can't put it in a stock that's currently valued at $1B. But if you have $1000, you don't have that constraint.

Regardless of how the optimal portfolio may differ, when you're investing a relatively minute amount compared to the entire market, it's hard to imagine the optimum is not going to be different.

...You don't pilot your car under all the same constraints as an 18-wheeler, just because that's optimum for shipping large quantities.

>If you have $100B, say, you can't put it in a stock that's currently valued at $1B. But if you have $1000, you don't have that constraint.

Your argument is that there is a mispriced security somewhere that can be bought at a low price. There is currently only 1B$ of it available and so the professional manager with 100B$ to spend just doesn't bother to pick up that money. But you with just 1000$ can do it instead. What makes the professional manager pass up on that opportunity? He has at least as much money as you, why doesn't he invest at least that amount?

In reality that opportunity doesn't exist. Companies can't be consistently mispriced lower because there is too much demand for their stock. That's not how markets work for anything.

Every cap weighted fund has a cutoff where it omits companies that are too small. But even the stocks that are barely large enough to include don't contribute much to returns.

I don't think the small cap stock is "mispriced". Rather, it has a different value for different investors, and the market price is a compromise. That means different investors should probably have a different amount of it in a portfolio.

It's an abuse of theory to claim that since the market is efficient, you should ignore the things that make you different from the total market. For example, suppose you invest in tax-exempt investments when you are in a low tax bracket, or even when you are investing in a tax free account. Is that optimal because markets are efficient? Of course not. Because the value set by the market does not take into account the way in which you differ.

The reason to believe in index investing is because you understand your own lack of knowledge and are honest about it. That's a good thing, but it doesn't justify pretending you don't know things that you do know. People seem to have the same issue with probability, I find.

I think you're arguing a point that isn't even being brought up in this thread or in the article.

Of course it's just fine to have an index fund that's weighted towards certain types of stock, e.g. there's the S&P 500, then various "woldwide" funds, EU-weighted funds etc. The risks & benefits of those are well understood. Nobody argues that different types of index funds shouldn't exist.

Similarly, there's funds that cater to specific regulations, e.g. investing heavily in "green" stocks which may be subsidized by the government, or avoiding certain taxes (e.g. lower turnover for lower capital gains).

Both of those are categorically different from supposing that you know better than other people that tech stock in 2017 is overvalued, and trying to move away from that in favor of something else. Now you're making an active investment move which history shows you're more likely to lose on as gain anything on.

>Every cap weighted fund has a cutoff where it omits companies that are too small.

The whole market isn't just S&P500 funds, if it was there wouldn't be much price discovery. But in the S&P500 I bet most cap weighted funds actually hold all the assets.

>I don't think the small cap stock is "mispriced".

For your argument to hold it has to be. Specifically it has to be priced lower than it should so that an equal weighted fund can outperform a cap weighted fund. If that was the case the large fund manager should pick up that opportunity anyway, even if he can only do it in a lesser percentage of his portfolio than the retail investor. When that then happens those opportunities disappear.

>That's a good thing, but it doesn't justify pretending you don't know things that you do know.

The problem is that you haven't named a single thing a retail investor knows that the 100B$ fund manager doesn't and can't take advantage of.

I'll be honest and admit that because of the WSJ paywall, I wasn't able to read the entire article. If an actively-managed-fund with much higher fees is trying to convince people that they can beat the market by cutting down on tech stocks, I agree with you that's BS.

However, if a passively-managed-fund with similar fees is claiming that you can lower your portfolio-risk by investing equally across many industries, that's an argument I find much more convincing. I had actually not considered this argument before, which is why I found the article interesting for bringing it up (perhaps tangentially).

This is an inherent property of all market cap weighted indexes. An alternative approach is equal weighted indexes, which have historically outperformed market cap weighted indexes. There's no free lunch though: this is a case of your typical risk/reward tradeoff. Equal weighted funds are more risky (volatile), but have higher historic returns than market cap weighted funds.

Some of them feature equal weighting across industry sectors as well as amongst separate companies. Here's an example of one (also note the high fees): https://www.guggenheiminvestments.com/etf/fund/rsp-guggenhei...

I personally just stick with VTI and VXUS for stocks (excluding my Airbnb & other startup shares), but I also have about 50% of my net worth in crypto (and I remain bullish).

What you want is an equal risk weighted SPY ETF - where each component is weighted such that the contribution to total volatility is equalized. This can be done using some off the shelf risk models from firms like MSCI. There was such an ETF (ERW), but it never really took off, and it no longer trades. Unfortunately these methods will just remain available to only more sophisticated market participants.

There's still a lot of opportunity for new types of passive index funds, using methods like you suggest. Maybe someone will start an up.

That's stretching the definition of passive investing. What the OP describes is an active strategy like any other. That you can automate it and wrap it in an ETF doesn't make it passive.

My hunch tells me specialized funds won’t beat cap weighted indexes from places such as Vanguard because of fees.

If you want to avoid the large cap companies but still want to use index funds, could simply buy mid & small cap index funds [1]. Of course more risk with smaller caps.

[1] such as ones based on the Dow Jones U.S. Completion Total Stock Market Index which holds the 500th to 5000th largest companies

Why are you so bullish in crypto? Would love to hear your thoughts here (or send me a DM if you prefer).

I usually direct people who ask about this toward Andreas Antonopoulos and Tom Lee (of Fundstrat). Bitcoin's value seems to mimic that of social networks, which suggests that Metcalfe's law applies. I don't trust governments, especially in the US where we have rampant crony capitalism, and I'm anti-borders, anti-military, and anti-authoritarianism.

There's plenty of good information on Reddit (/r/Bitcoin is pretty good, /r/btc is more like InfoWars), but of course you need to be able to wade through the BS. I'm a Bitcoin maximalist (and have about 80% of my holdings in Bitcoin), with some ETH and LTC, and a long list of alts that I think might have potential.

I also don't recommend investing in Bitcoin (or any other cryptocurrency) unless you have a high tolerance for risk and can afford to lose it.

Here's an aantonop playlist if you want to binge: https://www.youtube.com/playlist?list=PLPQwGV1aLnTthcG265_FY...

When it comes to an index like the S&P 500 where even some of the smaller components (e.g. Church & Dwight Co (read: Arm & Hammer), Hilton, etc) would be considered "large cap" then you probably want to do equal weighting rather than market cap weighting.

When it comes to something like Vanguard's Total Market, you probably want to put more money into the blue chip stocks than into the smaller companies at the bottom of the list (sorted by market cap). Smaller companies have lower trade volume/are less liquid which makes them subject to greater volatility/price fluctuations. There is no sense taking on greater risk there when the reward opportunity doesn't meaningfully increase with it.

>Equal weighted funds are more risky (volatile), but have higher historic returns than market cap weighted funds.

But do they outperform after risk adjustment? I doubt it and if not you're better off just leveraging a bit to your desired level of risk. The point of passive investing isn't that the trading strategy can be automated, the point is to say "I want to grab exactly the average return of the market every year". Trying to do anything else is by definition not achievable by everyone so why do people think they should be the lucky ones? What specific advantage does a retail investor bring to merit that?

I don't think it makes sense to equate risk with volatility. Say I have $1M. If I buy a cap weighted S&P 500 fund, I have about $40,000 in Apple, because it's about 4%. If I then switch to an equal weighted S&P 500, that $40K will be split up between 20 stocks with about $2K each. That is clearly more diversified with respect to company specific risk. It may or may not be worth it given increased fees, but you can't just dogmatically say it's equivalent to cap-weighted plus leverage. It's qualitatively different.

>you can't just dogmatically say it's equivalent to cap-weighted plus leverage

I'm saying it's strictly better to do cap-weighted plus leverage. That's what financial theory tells us anyway, that the best portfolio is whatever mix between risk free cash and the same mix as all the assets in the world. Deviating from that brings you farther away from the efficiency frontier. Now for this to hold EMH must hold and we know it's not true in the stronger forms which was why I was asking for a risk adjusted benchmark.

I don't think there's a theory that tells you risk is volatility. Isn't that more of an axiom? And I have the distinct impression it was chosen because it leads to tractable math. I'm not endorsing a specific alternative definition of risk, but I was suggesting risk is clearly multidimensional and intimately related to predicting what will be correlated in the future.

50% in crypto? Good luck man, that sounds very risky.

It could easily have started out as 5% in crypto a year ago and just recently grew to be 50%.

Closer to this, but with different numbers.

doesnt change how risky it is

Well you could always avoid the tech heavy indices, but then you're sort of actively managing your positions rather than letting it be purely passive.

Theoretically, is not another growing peril of indexing that it removes incentives for companies to behave well or outperform, since if they're part of an index their shares will be bought automatically by retirement plans and investors anyway, irregardless of performance or competency?

And yet another theoretical peril question would be, if everyone is indexing, it surely must lose it's efficacy because it is no longer efficient, will indexing then not underperform? I suspect if or when that happens, active management will regain interest.

Indexing by the masses is a fairly new trend, it will be interesting to see how the markets handle the behavior long term.

This is not quite correct. There are other weighting methods (specifically, equal weighting) which would prevent this situation, whilst still remaining passive.

You would have to actively rebalance to keep equal weighting, so it is not as passive as typical market cap weighting.

You still have to rebalance market cap weighted funds, just much less so. Market cap weighted is indeed more efficient, but that's only assuming most stocks don't do things like pay dividends.

I'd argue an equal weighted index is no longer passive. You're actively making a bet that smaller companies will outperform bigger companies. Someone else will be taking the other side of that bet. Me with my cap weighted index will get the average of the two and be actually passive.

But many investors are going to take the side of big companies, not because they are choosing the optimal approach, but because they have to, because they have too much capital to invest in small companies. So it's not logical to assume their returns must be equal on average.

I didn't say their returns would be equal, I said my returns will always be equal to the average of the market exactly because I'm a passive investor. The sum of all bets is what I'll be making. The standard text on that:

https://web.stanford.edu/~wfsharpe/art/active/active.htm

As for there not being enough of the small companies available to do the equal weighted S&P500, the smallest companies in the index have 3.5B$ in market cap. So there's almost 2T$ of that mix available and there would be much more if that amount of capital suddenly decided to implement that strategy as the market caps of the bottom of the S&P500 index would certainly rise significantly.

I suspect we will reach an equilibrium where most people are indexing and a few very good active managers are in play, while most of the less competent managers have been booted out. There might be a few swings towards either side on the way to that steady state.

The problem is that the pool of "few very good active managers" is changing all the time.

And if you happen to find an outperforming active manager, it's like buying high -- managers, like the market, always revert to the mean.

I totally get what you are saying, I am just saying that people will still fall for active managers like they do today, although in far fewer numbers and active managers will not completely go away. Also, when almost all people are indexing there will be a few arbitrage opportunities for active managers.

> it surely must lose it's efficacy because it is no longer efficient, will indexing then not underperform

Well, it's just a question of competitive advantages. In a world where so many people are trying to outperform the market, it's really hard to outperform the market and index funds essentially piggy-back to the aggregated wisdom of the best investors. In a world when the majority of investment and trading (the price is set by the marginal investor, not by the average investor) is index funds, outperforming the market will be easier. In reality, you get a sensible balance.

Index funds don't have to do the majority of trading as long as they cannibalize the trading that would have occurred. Say that the majority of investable dollars is held in index funds that rebalance once/year, only trading then. The effect on liquidity & prices is that fewer trades are made and relevant information on the stock's future prospects takes longer to get reflected in the price. This opens up profitable investment opportunities for active fund managers to move in and buy up underpriced assets before the passive investments get in there, which then corrects the pricing imbalance (but not before the active fund managers have made a good profit).

"Theoretically, is not another growing peril of indexing that it removes incentives for companies to behave well or outperform, since if they're part of an index their shares will be bought automatically by retirement plans and investors anyway, irregardless of performance or competency?"

You don't have to look far to find this ... a great example is Restoration Hardware, which very recently borrowed money to buy back roughly half of the outstanding shares:

"The move has caused the company to consume basically all of its available cash balances and debt to increase by $500 million. In consequence, stockholder's equity has swung from $920 million at the end of the company's last fiscal year into slightly negative territory."[1]

This squeezed the shorts as well as (to the uninformed) bolstered their EPS dramatically as there are half as many shares now outstanding.

Nobody but an industry insider or other market-specific trading desk would have any interest in a disaster of a stock like this, and yet RH is in the Russell 3000 and is therefore auto-purchased by savers and retirees everywhere.

"if everyone is indexing, it surely must lose it's efficacy because it is no longer efficient, will indexing then not underperform?"

This was explained, I think, very succinctly in the Dave Collum "year in review"[2] wherein he explains:

"In his must-read book The Wisdom of Crowds, James Surowiecki posits that a large sample size of non-experts, when asked to wager a guess about something—the number of jelly beans in a jar, for example—will generate a distribution centered on the correct answer. Compared with experts, a crowd of clueless people offers more wisdom. I submit that this collective wisdom extends to democracies and markets alike. A critical requirement, however, is that the voting must be uncorrelated. Each player must vote or guess independently."

And that is precisely the issue we are worried about facing with index funds - we are buying indexes so as to access the (real, efficacious) wisdom of the crowd. However, if nobody actually makes a best guess - if there are no participants in the "guess voting" the wisdom of the crowd is lost.

[1] https://seekingalpha.com/article/4104757-shorts-restoration-...

[2] http://www.zerohedge.com/news/2017-12-23/dave-collums-2017-y...

The crowd's wisdom extends to the indexer. Another issue with these index-linked funds is that they create a single point of failure, i.e. the few people at Russell that curate the index. It would be very very easy for someone to, um, externally compensate an individual or two at Russell to include a dog in the index for the purpose of a massive stock pop. Similar to the bond-rating agency fiasco(s) leading up to the 2008 crisis.

However, once an index is compromised like this, its overall returns will begin to suffer and people will move out of, say, Russell-linked funds. If it gets bad enough across the board, active-managed funds will begin to consistently outperform index funds and people will move their money there ... which presumably will rebalance the indexes. As far as I can see it, over the long term the system should self-correct.

It would also be pretty easy to spot something like that happening. If you see a stock in the Russell 3000 that is substantially less valuable than the distribution's tail would lead you to expect, then somebody is probably fucking with things. I would be astonished if Vanguard and other fund managers do not have automated monitoring to detect cases like this.

I think you hit something right on the head. The index itself is defined by a formula that we generally agreed upon. We only need to have more choices of formulas...Russell is capitalization based - maybe that is too simple? Can we make a Hacker News 5000?

"Tech" in this case is an overly broad classification. Apple, Amazon, and Facebook are all very different businesses and should not have correlated performance.

Logistics, hardware, advertising. All very different for sure.

Every successful business has to be “tech” in this century. Tech is how you achieve high scale

Yeah, if "tech" just means "many employees are programmers" or "has a large online presence" it seems obvious that tech is going to become a larger portion of the market, and rebalancing to cut down the "overweight" tech in your portfolio runs directly counter to what passive cap-weighted investing is about -- having investments that follow what has won in the past and is expected to win in the future.

This looks like a PR piece to make people afraid of investing in the S&P. Some people have suggested thought that since investing in index funds makes the companies that are apart of the index fund to not compete with each other due to their shareholders. I'm not sure if the previous statement is even valid or real.

There have a lot of hit jobs on index funds in the last few years, often published in the Wall Street Journal. Active fund managers are getting really scared that money continues pouring out of them and into Vanguard as it becomes common knowledge that actively managed funds almost never beat index funds net of fees.

https://news.ycombinator.com/item?id=12368136#12368902 <- I said this a year ago and it's going to continue

The growing peril is only for long positions. Peril for long positions is profit for short positions.

Seeing this article advising "reducing your exposure to tech by selling your tech stocks" assumes that you have no choice to participate other than buying. They are looking at half of the market(buy-side) and ignoring the equal-sized selling-side of the market. Stocks going down == Short the market. Stocks going up == long the market. The direction is unimportant, the volatility is absolutely important - and there is an awful lot of it(volatility) at the moment.

Are you suggesting an index fund that passively shorts everything? I don’t think that’s in my 401k.

(I use Hedgeable which is the most complex robo-advisor, but as they say they hedge long instead of using options. Please sign up, I’d be inconvenienced if they went out of business!)

I'm suggesting if the article has any conviction for moving out of tech, then the smart play is not to move out but to short. The language of "reduce exposure" is not what you should hear from your advisor/broker. You don't reduce exposure, you reduce risk by opening short hedges or opening short outright. If these people are tied up long in QQQ(the article references this instrument, which is an amateur hour NQ100 ETF), then risk of tech bust is managed by shorting NQ as a hedge.

"The direction is unimportant, the volatility is absolutely important - and there is an awful lot of it(volatility) at the moment."

I am not sure what you mean by this - the asset market in general and the stock market in particular is historically non-volatile right now. Almost all asset classes are in lock-step correlation and fear indexes like the VIX are in such permanent languish that shorting the VIX has been one of the more profitable strategies for trading desks over the last few years.

http://archive.is/qPANt

Balancing your portfolio with domestic (US) and international index funds would seem to take care of that since.

I'm currently 60/20/20 US/International/Bonds IIRC.

If the US market is mostly tech and tech bottoms out when I want to retire, I won't be completely wiped out.

I also plan to semi-retire early and work a lower stress job between 40/50 and 65 so I'll be less under the gun than someone who needs sell stock and can't tighten their belt.

Aren't there any broad non-tech index funds?

VDC tracks consumer staples, which doesn't include any of the major tech companies.

Looks like Pro Shares has S&P 500 ex Tech: http://www.proshares.com/funds/spxt.html

ADV of 311 shares according to Yahoo. Do not buy.

Vanguard has a lot of sector specific funds, such as VPU, VNQ, VAW, VIS, VDE, and others. But a lot of the funds track by Market Cap or are Bonds

$SPXT (SPY-ex tech sector) would qualify, but it has almost no volume, so I would recommend against trading it. You could construct something roughly equivalent by going long x shares $SPY and then going short ~0.238 * x shares of $XLK.

I don't think shorting would be a very good strategy for passive, long term investors due to the associated costs (margin, dividend payments) and the unlimited risk.

There isn't unlimited risk because the exposure to tech is hedged out by the opposing long/short positions (as are the dividend payments). Agreed that this isn't practical for the average investor though.

Are they tracking the same tech stocks in a proportion that cancels out?

Yes, $XLK tracks the technology sector components of the SP500.

There are index funds that track the Russell 2000. This is a smaller-cap index. I suspect that it has some tech in it, but I also suspect that it is less tech-heavy than the S&P 500.

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