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Comment by Beijinger | Hacker News Reader

All this is true, and there are many good comments in the thread here. But this "hey dude, stock picking is for idiots and all non idiots but index funds" should be treated with caution. Index funds are an extremely clever idea but were never meant to be used on such a scale.

To give you some ideas:

https://www.forbes.com/sites/chriscarosa/2024/04/02/index-fu...

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Index funds are not some clever hack, they are just tracking the combined productivity of the publicly traded companies that make them up. Whole market, or the top 500 as a representative slice, whatever. When you buy the whole US market for example you are saying, "I strongly believe that the overwhelming majority of companies in the US want to make shitloads of money and pass it down to themselves and their shareholders."

Index funds will never bring down the market as long as individuals and companies are allowed to trade individual stocks at prices of their choosing. There will _always_ be someone who thinks a particular stock is overvalued or undervalued. Those people set the prices.

Something I've wondered is how index funds effect companies entering the index for the first time.

Like, let's say there's a company (TryerCo) that is the 501st biggest in the US. Big, but still one step away from being in the S&P 500.

Then, one of the S&P 500s collapse. They exit the index, and TryerCo enters the index at position 500, despite no material change since the day before.

Doesn't this mean a whole _heap_ of index funds will suddenly start buying TryerCo stock, sending it up thanks to the arbitrary number 500?

The ETFs are generally rebalanced once a quarter, so yeah, it really is a big deal when a company enters one of the main indices, and the price starts to move up in anticipation of the listing, then stays up because the ETFs, as you intuit, have to start buying it as a component of the market. Supermicro entering S&P500 and Arm entering Nasdaq 100 being good examples recently.

This is basically priced in based on the odds of entering an index in the same way that potential acquisitions get priced in based on the odds of the acquisition going through.

I swear I've seen actively managed funds that explicitly trade based on stocks' potential to enter/leave indexes, but it's a terrible batch of terms to try to google.

You can search for research that studies this exact index effect. Short term: yes, but it wears off quickly.

One of my big brain investing ideas is to pick the stocks at the top of the index instead of buying the whole index. If index funds continue to rise in popularity, the stocks that are at the top will benefit most from passive investment volume.

Plus, index funds follow a kind of Pareto principle where the top stocks contribute disproportionately to the total return anyway.

As I’ve gotten older though, one of my realizations is that the tax-free rebalancing of index ETFs is their most valuable property, rather than their actual choice of equities.

I had an active manager reach out to me with exactly this strategy.

I didn't look at the fees or rebalancing schedule super closely, because I didn't want to invest with the guy, but IMO his market-beating claims were due to increased concentration during a bull market (risk) which could go sideways fast if he didn't rebalance at opportune times.

Which, without looking, probably means NASDAQ today--and certainly the top 50 or whatever tech stocks by whatever metric. That didn't look so great in late 2001. Certainly my T Rowe Price tech fund cratered. Tech has been very good, even relatively speaking through the great recession, since then.

The best approximation I’ve found is S&P has this Top 10 index[1]. Over the last 10 years it has performed 18% annually vs 11% for the overall S&P 500, but that’s obviously been a historic bull run in large cap growth stocks. I can’t find data going back to 2000 to see how that strategy would have played out, but curious if someone else finds it or crunches the numbers.

1. https://www.spglobal.com/spdji/en/indices/equity/sp-500-top-...

Yeah, for what it's worth, my financial advisor is pushing me towards more value stocks and some more bonds. (I am somewhat older as well in addition to be in a position where being conservative makes sense.) Was just doing some research.

What do you pay for that advice?

https://www.aqr.com/Insights/Perspectives/Value-Spreads-Back...

I’d be cautious that you are about to get a wicked mean reversion.

Yeah to clarify, I don’t necessarily recommend (or even follow) this strategy, I still mostly invest in passive index funds.

Ah I see, carry on then!

There is an old strategy that is kind of the inverse of this this called Dogs of the Dow where. You buy with stocks with the highest dividend-to-price ratio (implicitly underperforming), looking for the rebound.

https://en.wikipedia.org/wiki/Dogs_of_the_Dow

I don’t know for sure, but I have a hunch this strategy has done below-average for the past 10-20 years, because most of the above-average returns have been driven by growth stocks with low dividends. Stock buybacks have also become a really popular way of returning value to shareholders instead of dividends.

Hint: this idea has been around for as long as index funds have been around, if it actually worked well, everyone would be doing it. Alas, a big part of why index funds work well in the long term is diversification, and when you cherry pick a subset you also lose out on diversification. It's one of those strategies that looks clever if you don't delve into it, but actually the returns are worse. As an example, if you take the SP100 it might outperform the SP500 on single year performance every now and then, but in the long term, SP500 has consistently outperformed it.

Do you have data to back that up?

You can pull up SP100 and SP500 and look at their historical returns. SP100 is an actual index, not something I made up for illustration. If you look at the last 40ish years, SP100 is up roughly 45 times, SP500 is up roughly 50 times.

What might help understand this concept intuitively is if you take it to the extreme: what if you always held only the very first company of the SP500. Sure, you would have a lot of the upside, but you would also be completely naked to the downturns. Similarly, you would lose a lot of money on commissions whenever the leader changes. Taking any other smaller subsection has the same problems, it's simply a matter of what tradeoff works best for you.

Sorry I know what you mean - I’m just having trouble finding any data source / website that shows useful comparisons going back that far - what website are you looking at?

These are the 10 year returns I’m seeing according to S&P:

S&P 500: 11.1%

S&P 500 Top 50: 13.2%

S&P 500 Top 10: 18.1%

The trend is pretty clear, at least in the last decade. My other point was that the historical data may not be as relevant because the index is much more top-heavy today, perhaps in part due to the popularity of index funds and part because the top companies are actually outperforming.

Here’s an article to that effect - the top 20 stocks in the S&P accounted for ~90% of the index’s gains last year: https://www.visualcapitalist.com/cp/top-20-stocks-sp-500-ret...

To your question about picking the extreme Top 1 stock - again I’m having trouble finding good data on that, but I’d be curious what the hypothetical outcome would have been over the last 20 years.

I use IBKR for data, but you could also get ticker data from Yahoo Finance or other similar sources, albeit manually since they don't have an API afaik. A simple although simplistic way to backtest ideas like this is Portfolio Visualizer [0], you need an account, but a free one should work. I've uploaded a screenshot of a sample run where the top company in SP500 was held for a year and then swapped out if needed on an annual basis [1]. There's a few things I'd like to highlight.

Firstly, for a considerable majority of history, often for years at a time, holding the top one company, I'll just call it SP1, underperforms the index. The maximum downturn for the SP1 was 79% and I think very few people could stomach holding that for years at a time, hoping things will improve.

Secondly, pretty much the only reason the SP1 strategy comes out on top is the fact that AAPL has gone up about ten times (!!) in the last decade or so. Whether that's the new norm in the markets or an absolute anomaly I'll leave up to you. In short, the only real reason the SP1 strategy has looked favorable, and I suspect the same holds for the SP10 and SP50 if you backtested them, is that Apple has seen its value skyrocket.

Needless to say that none of this is investment advice etc.

[0] https://www.portfoliovisualizer.com/backtest-dynamic-allocat...

[1] https://ibb.co/st8mmq0

Thanks for following up - just saw this!

100% you're just adding additional volatility for higher returns. Backdate the strategy, doubtful you're beating the overall index on decade timescales.

On the contrary, that article makes it seem perfectly fine to invest in index funds.

There are a lot of unknown for the markets in the future. Also the 0 or negative interest rate environments we will probably enter (again).

IMHO we need to rethink or tweak the financial system sooner rather than later.

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