Author Topic: Does the passive trend create an index bubble?  (Read 2016 times)

justostash

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Does the passive trend create an index bubble?
« on: November 25, 2017, 02:14:37 PM »
It seems there have been a couple short conversations about this topic, but I just wanted to see what the latest thoughts on this are. Passive index investing as we know is at an all-time high with popular index funds, Bettermint, Wealthfront, etc leading the way. These products are funneling much money into the major indexes, possibly more attention than ever to stocks contained within the indexes. What does everyone think about this? Does this continuous flow of money into a minority of large stocks create a top-heavy market? Please forgive my ignorance, but it's just something I've been thinking a bit about lately.

Indexer

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Re: Does the passive trend create an index bubble?
« Reply #1 on: November 25, 2017, 03:58:31 PM »
Short answer: no, I'm worried about an index bubble.

I don't think Betterment or Wealthfront should get any credit for this. Betterment has 10 billion in assets. Wealthfront has 7.5 billion.

Vanguard has 4.4 Trillion in assets. Blackrock also has a lot of index assets, and they manage 6 Trillion. (Not all of these assets are index funds, both companies also have active funds.)

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Does this continuous flow of money into a minority of large stocks create a top-heavy market?

The largest index fund is VTSAX. It doesn't track large stocks. It tracks about 3500 different companies including mega, large, mid, small, and micro caps.

Active shops have been trying to say there is an 'index bubble' for years now. Total market index funds buy everything so they aren't over weighting any asset. For index funds to create a bubble you would need so much money in index funds that they distort the market. Keep in mind active managers are looking for valuation distortions so they can take advantage of them, and they correct the distortions in the process. This is what keeps our market efficient. One sign that indexing is too big is that stocks would just move with the index, and not based on their own fundamentals. This isn't happening. Stocks still move based on their own merits. Look at the FANG stocks as an example, or energy stocks, or banks, etc. etc. etc.
« Last Edit: November 25, 2017, 04:02:29 PM by Indexer »

L.A.S.

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Re: Does the passive trend create an index bubble?
« Reply #2 on: November 26, 2017, 03:14:41 PM »
I don't see it having much effect.  I think there are enough other actors in the market such as hedge funds, institutional investors, high-frequency traders, insiders, and the corporations themselves, to cause effective price discovery for all of the individual issues in an index.
« Last Edit: November 27, 2017, 07:04:12 AM by L.A.S. »

Mighty-Dollar

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Re: Does the passive trend create an index bubble?
« Reply #3 on: November 26, 2017, 07:10:29 PM »
Investing in an index is a form of rules based investing. As with any rules based investing you're going to get more volatility. The subject stocks are going to benefit on the way up but be adversely effected on the way down. But if you're a long term investor, who cares? It's all going to even out. As long as index investing keeps becoming more popular then it's gonna be a net benefit.

The real question is whether index investing beats actively managed investing -- not whether index investing is a bubble or not. Study after study, year after year, active managers cannot beat the indexes. Usually it's somebody who is TRYING TO SELL YOU SOMETHING (annuities, gold, actively managed mutual funds, life insurance) who is trying to scare you out of index funds.
« Last Edit: November 26, 2017, 07:15:39 PM by Mighty-Dollar »

MustacheAndaHalf

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Re: Does the passive trend create an index bubble?
« Reply #4 on: November 27, 2017, 08:44:24 AM »
Have you noticed all prior bubbles involve active buying and selling?  That includes the 2008 crisis over CDOs being created and sold, real estate being bought and sold, etc.  A bubble involves activity - both buying and selling.

If you are truly a passive investor, you're not selling.  Even if there's a bubble, nobody is selling, so there's nothing to burst.  The bubble bursts when everyone leaves.

Another problem is that market prices reflect buying and selling - not holding.  Passive indexing doesn't participate in the market except to buy occasionally.  Meanwhile active market participants are buying and selling all day long.  The volume of trading is more important to the market than the overall level of assets passively doing nothing.

thenextguy

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Re: Does the passive trend create an index bubble?
« Reply #5 on: November 27, 2017, 08:50:37 AM »
Short answer: no, I'm worried about an index bubble.

I don't think Betterment or Wealthfront should get any credit for this. Betterment has 10 billion in assets. Wealthfront has 7.5 billion.

Vanguard has 4.4 Trillion in assets. Blackrock also has a lot of index assets, and they manage 6 Trillion. (Not all of these assets are index funds, both companies also have active funds.)

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Does this continuous flow of money into a minority of large stocks create a top-heavy market?

The largest index fund is VTSAX. It doesn't track large stocks. It tracks about 3500 different companies including mega, large, mid, small, and micro caps.

Active shops have been trying to say there is an 'index bubble' for years now. Total market index funds buy everything so they aren't over weighting any asset. For index funds to create a bubble you would need so much money in index funds that they distort the market. Keep in mind active managers are looking for valuation distortions so they can take advantage of them, and they correct the distortions in the process. This is what keeps our market efficient. One sign that indexing is too big is that stocks would just move with the index, and not based on their own fundamentals. This isn't happening. Stocks still move based on their own merits. Look at the FANG stocks as an example, or energy stocks, or banks, etc. etc. etc.

I'm not arguing with your overall point, but VTSAX is not the largest. I know at the very least VFIAX is larger.
« Last Edit: November 27, 2017, 08:53:57 AM by thenextguy »

Indexer

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Re: Does the passive trend create an index bubble?
« Reply #6 on: November 29, 2017, 08:15:39 PM »
I'm not arguing with your overall point, but VTSAX is not the largest. I know at the very least VFIAX is larger.

You are mistaken. VTSAX is the largest.

VTSAX= 635 billion in assets.
VFIAX = 367.5 billion in assets.

chasesfish

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Re: Does the passive trend create an index bubble?
« Reply #7 on: November 30, 2017, 05:08:45 AM »
There isn't necessarily an "index" bubble, but there are some interesting side effects that will come from the masses of population primarily indexing either the S&P 500 and/or the Total Stock Market Index.

Larger Companies will trade at a higher premium than smaller companies.   This means small and mid-cap companies  will be forced to provide a higher return to attract the same amount of capital, which really isn't a change, but it makes the markets more efficient.   People with a very long-term time horizon will probably benefit from having a higher allocation towards small and mid cap companies than just holding the S&P 500.

The bigger concern I have over the rise of indexing is corporate governance.  Vanguard, Blackrock, and Fidelity will control a large percentage of the voting shares of companies and "index/passive" investing by its theory means not taking a stance on corporate issues.  They outsource those decisions to three proxy advisory firms and it takes gross negligence by leadership and a strong activist investor for the Big 3 to ever vote against existing management (Think Darden Restaurants).

This allows a company like ADP to have an insulated board of directors that only owns 0.3% of the company and approve issuing large sums of restricted stock to management, diluting shareholders.  The only way this is exposed is for an activist investor like Bill Ackman to come in, spend tens of millions of dollars of his own money exposing this, then having to spend money on a big public campaign to expose issues to the Proxy Advisory Firms (he lost this battle by the way).  Then the company's management is not only enriching themselves at the shareholder's expense, they then get to use the company's money (ie shareholder's money) at an almost unlimited supply to fight the activist investor.   

Ackman's fight was basically as a 3-4% shareholder, he wanted a couple of board seats.  His fund owned 10x more of ADP stock than the entire board of directors.  They were worried about uncomfortable questions and accountability if he was let into the "board club". 

This is the reason Jeffery Immelt could use GE Shareholder's money to fly a second corporate jet behind his first corporate just "just in case" something went wrong. 

I expect we will continue to see a rise of activist investors and proxy contests against management/boards that are not being good stewards of shareholder money.

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trollwithamustache

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Re: Does the passive trend create an index bubble?
« Reply #8 on: November 30, 2017, 08:24:16 AM »
The term index can be misleading. Something like VTSAX, which many here may own and pherhaps even love, keeps its share composition constant.

There are lots of ETFs and index funds out there that have some goofy rules on their composition for a sector. These funds can be "passively" rebalancing on a regular basis to maintain average dollar values in each index component instead of simply holding an index of say10 companies in a sector on a set 1:1:1...  basis. 

Your average financial writer seems very comfortable dumping these sector products into the same discussion with VTSAX type funds as index funds.

BTDretire

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Re: Does the passive trend create an index bubble?
« Reply #9 on: November 30, 2017, 10:44:15 AM »
I think the effect of massive amounts of money in index funds will be that smaller amounts of trading will cause larger market moves. Up or Down.

thenextguy

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Re: Does the passive trend create an index bubble?
« Reply #10 on: November 30, 2017, 11:18:19 AM »
I'm not arguing with your overall point, but VTSAX is not the largest. I know at the very least VFIAX is larger.

You are mistaken. VTSAX is the largest.

VTSAX= 635 billion in assets.
VFIAX = 367.5 billion in assets.

I was looking at this: https://www.investopedia.com/investing/biggest-mutual-funds/

But if you include all the share classes, you are correct.

seattlecyclone

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Re: Does the passive trend create an index bubble?
« Reply #11 on: November 30, 2017, 11:48:45 AM »
As long as there's at least a very sizable minority of investors actively trading to create some reasonable consensus for what each stock is worth, I think we'll be fine.
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anisotropy

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Re: Does the passive trend create an index bubble?
« Reply #12 on: November 30, 2017, 12:13:47 PM »
I am not sure. The hypothesis is that as more and more people go passive, the "value gap" due to inefficiencies will be easier to exploit by the active pros. But as Felix Zulauf pointed out, for the value to actually materialize, the market need to acknowledge it as a whole. The paradox lies in that, when most of the market is simply doing index, the value might never materialize.

Personally I don't think the passive trend is currently creating bubbles that we've known. They typically came from highly leveraged positions, which appears to be less than copious for now.

chasesfish

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Re: Does the passive trend create an index bubble?
« Reply #13 on: December 01, 2017, 06:23:13 AM »
I would also add that the speculators and "dumb money" that usually drives bubbles (think tech in the 90s, housing in the mid 2000s) seems to be obsessed with bitcoin at the moment. 
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Indexer

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Re: Does the passive trend create an index bubble?
« Reply #14 on: December 02, 2017, 11:29:30 PM »
There isn't necessarily an "index" bubble, but there are some interesting side effects that will come from the masses of population primarily indexing either the S&P 500 and/or the Total Stock Market Index.

Larger Companies will trade at a higher premium than smaller companies.   

Total stock includes mid, small, and micro caps. This is not an issue with total market index funds. It is a problem with 500 index, no argument there.


Quote
The bigger concern I have over the rise of indexing is corporate governance.  Vanguard, Blackrock, and Fidelity will control a large percentage of the voting shares of companies and "index/passive" investing by its theory means not taking a stance on corporate issues.  They outsource those decisions to three proxy advisory firms and it takes gross negligence by leadership and a strong activist investor for the Big 3 to ever vote against existing management (Think Darden Restaurants).

What part of passive investing states that you can't take a stance on corporate issues? Blackrock and Vanguard recently voted, against management, in favor of a shareholder proposal forcing Exxon to research and disclose it's regulatory risks associated with climate change. In addition, there is a reason these companies vote with management most of the time. If managements wants to propose anything out of the ordinary they are going to consult their largest investors before they propose the vote. Plus all three companies keep their corporate governance voting rules available on their websites. Management would be pretty stupid to put forward a proposal they know all three will vote against. Those companies vote with management so much because management puts forward proposals they know the companies will vote for.

Quote
Ackman's fight was basically as a 3-4% shareholder, he wanted a couple of board seats.  His fund owned 10x more of ADP stock than the entire board of directors.  They were worried about uncomfortable questions and accountability if he was let into the "board club". 

He bought stock in a company so he could try to put himself on the board because he thought he could run the company better than the people currently running it. Then he was surprised when they banded together and said no. If he doesn't like how ADP is run he shouldn't be buying it. Look, I love how he exposed Herbalife for what it really was, but in that case he shorted the company because he thought they were terrible. That's very different from buying a company he thought was bad and then trying to fix it himself. If you don't like the way a company is run, don't buy it.

ChpBstrd

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Re: Does the passive trend create an index bubble?
« Reply #15 on: December 03, 2017, 08:27:59 PM »
You could look for the following signs:

1) Active managers start beating passive funds over a period of maybe 5-10 years. In that timeframe, return on invested capital has a bigger influence on a stock's price than the movement of the herd. It might take this long for the proposed inefficiencies to be exploited.

2) Stocks that are part of a popular index will be more expensive than stocks with similar metrics outside the index. Then the next hot trend will be active managers attempting to push companies into an index. Think stock #2001 in the Russell 2000, that just isn't part of the index yet, but could be if sales increased 5% or whatever. Because a flood of mindless money will begin pursuing the stock once it changes rank from #2001 to #2000, active managers who could push it over the edge through leverage or mergers of convenience will do so and then sell their stakes once the indexers take ownership and bid up the shares.

3) Even when companies have a bad quarter or a disaster, their stock prices don't move significantly, because there are not enough active traders making event-based decisions to move the needle. (of course, this would soon lead to arbitrage. See #1.).

chasesfish

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Re: Does the passive trend create an index bubble?
« Reply #16 on: December 05, 2017, 06:02:31 AM »
Indexer - Good discussion points above.

I think its incredible difficult to get the Vanguard/Blackrock's of the world to pay attention and its unfair the existing management gets to fight with shareholder money, regardless of the right/wrong.   ADP's management and board only having 0.5% ownership doesn't lead to solid governance.   I actually work for an S&P 500 company with the same issue, strongly insulated board and almost all internal management providing less than market returns, so the issue feels very real to me.  I also work in an industry where shareholders are basically prohibited from owning more than 10% of the oustanding stock.  You occasionally can get their attention, like with the ouster of Darden Restaurant's board for woefully wasting shareholder money.

There's also a case that activists improve performance, even if they never get a board seat.  I owned some stock in Cracker Barrel I bought almost five years ago, an activist drove that company to right their ship while they publicly blocked him from a board seat.

My point/opinion is the only other area where value is created from this long-term trend is through activist investing or following activist investors, but the game is stacked against the activist when management can spend other people's money to fight and it relies on Vanguard/Blackrock taking a stand
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anisotropy

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Re: Does the passive trend create an index bubble?
« Reply #17 on: December 05, 2017, 11:18:58 AM »
Here is a Bloomberg article that relates to the topic, note the discussion on Japanese market.

https://www.bloomberg.com/news/features/2017-12-04/blackrock-and-vanguard-s-20-trillion-future-is-closer-than-you-think

"By contrast, in Japan, nearly 70 percent of domestically focused equity funds are passively managed, suggesting the U.S. can stomach more indexing before market efficiency suffers"


dougules

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Re: Does the passive trend create an index bubble?
« Reply #18 on: December 06, 2017, 04:04:41 PM »
I have a hypothesis that more passive investors will reduce the number of traders who don't know what they're doing.  Then prices will be more and more set by people like Warren Buffett who are buying and selling based on homework instead of hunches. 

gerardc

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Re: Does the passive trend create an index bubble?
« Reply #19 on: December 06, 2017, 09:01:35 PM »
I'm not worried about indices going into a bubble relative to other stocks, but I'm worried that the mainstream investing advice is now along the lines of "invest in an index, the market always goes up in the long term, you can't go wrong with an index if you hold during the lows, etc." which is only based on historical data where this advice wasn't present, and creates a surplus of money in the stock market (demand >> supply).

Historically, when there was a downturn, people were afraid, sold in masses, started working to get back on track, etc. but I wonder if with this newfound wisdom, people would just keep buying during lows, so there won't be lows anymore, and "holders" will lose their comparative advantage since there won't be any more "suckers" / losers in the game... nomsayin?

jleo

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Re: Does the passive trend create an index bubble?
« Reply #20 on: December 06, 2017, 09:14:15 PM »
I'm not worried about indices going into a bubble relative to other stocks, but I'm worried that the mainstream investing advice is now along the lines of "invest in an index, the market always goes up in the long term, you can't go wrong with an index if you hold during the lows, etc." which is only based on historical data where this advice wasn't present, and creates a surplus of money in the stock market (demand >> supply).

Historically, when there was a downturn, people were afraid, sold in masses, started working to get back on track, etc. but I wonder if with this newfound wisdom, people would just keep buying during lows, so there won't be lows anymore, and "holders" will lose their comparative advantage since there won't be any more "suckers" / losers in the game... nomsayin?

I was actually thinking this the other day, I always hear everyone say I will invest on the next drop... But I think the big money still plays the game and controls a large amount of what the market does.

chasesfish

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Re: Does the passive trend create an index bubble?
« Reply #21 on: December 07, 2017, 05:29:28 AM »
I believe that the markets get more efficient each year. 
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dougules

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Re: Does the passive trend create an index bubble?
« Reply #22 on: December 07, 2017, 10:48:50 AM »
I'm not worried about indices going into a bubble relative to other stocks, but I'm worried that the mainstream investing advice is now along the lines of "invest in an index, the market always goes up in the long term, you can't go wrong with an index if you hold during the lows, etc." which is only based on historical data where this advice wasn't present, and creates a surplus of money in the stock market (demand >> supply).

Historically, when there was a downturn, people were afraid, sold in masses, started working to get back on track, etc. but I wonder if with this newfound wisdom, people would just keep buying during lows, so there won't be lows anymore, and "holders" will lose their comparative advantage since there won't be any more "suckers" / losers in the game... nomsayin?

I was actually thinking this the other day, I always hear everyone say I will invest on the next drop... But I think the big money still plays the game and controls a large amount of what the market does.

There will be another big panic, and everybody will go from "no more lows" to "no more highs."  The more things change, the more things stay the same.  The problem is when it does finally come it might have gone so high that it never crashes back to the point it's at now.  Honestly I think it should have crashed 3-4 years ago, but it could go for several more years before the cycle repeats.  Or it may be this afternoon.  Who knows.