Author Topic: As more people index in index funds  (Read 21465 times)

warfreak2

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Re: As more people index in index funds
« Reply #50 on: April 30, 2014, 05:53:45 PM »
Also to make up some false narrative that there are these two "warring groups" is a bit silly as there isn't any warring going on between them.
Normally, being false and being silly are desirable of a joke.

matchewed

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Re: As more people index in index funds
« Reply #51 on: April 30, 2014, 06:28:19 PM »
Also to make up some false narrative that there are these two "warring groups" is a bit silly as there isn't any warring going on between them.
Normally, being false and being silly are desirable of a joke.

Well it is laughable to think of HFT guys and index people lining up on a battlefield. One carrying keyboards hoping they can come up with an algorithm that predicts the outcome or snipes a few guys before they get their pants on. The other just willing to let the flow of the fight take them where it may... inevitable victory.

clifp

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Re: As more people index in index funds
« Reply #52 on: May 01, 2014, 06:11:56 AM »
Back on topic.

I think over the short term, there is little danger of active investors going away..  However, the growth of indexing is pretty steady.  I think we will see increasing pressure on 401K and 403(b) plans to offer index funds, and probably even some movement to make the default (401K) investment something like 50% S&P500/Total Market and 50% Total bond, or life cycle funds.

So the pool of money for active investor to manage will shrink.  Although most active managers can't outperform the market especially not by an amount that justifies their fees and expense, some can. 

In Michael Lewis, earlier book the Big Short, he talks about several investor/money manager etc. who figured out that many of the collateralized mortgage-back securities (MBS) were junk.  They made billions by creatively figuring out ways of shorting the mortgage market.  Aided in no small part by folks at Goldman Sachs and other Wall St. firms.  Now lots of people get understandable upset about shorts making billions off of the misfortune of others.  However, we can actually need more people not less question conventional wisdom, small caps out perform large caps, stocks outperform bonds,the market is or is not in a bubble.  Housing prices are too cheap or too expensive.

I suspect that are will always be healthy dose of skeptics and folks who think they are right and the rest of the market is dead wrong, and are willing to back their beliefs up with money.  The systemic danger to the stock market is that everyone will be so convinced that indexing is superior, that not enough people will be willing to turn their money over to the smart skeptics..

It is impossible to state for certain what would have happened if the guys in the Big Short, had just been folks with million portfolios and not a billion in some cases.  But certainly one possibility is that MBS's  could have continue  to go up another year or two and then crash even faster and harder. Doing more damage to the system.

matchewed

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Re: As more people index in index funds
« Reply #53 on: May 01, 2014, 06:23:35 AM »
Back on topic.

I think over the short term, there is little danger of active investors going away..  However, the growth of indexing is pretty steady.  I think we will see increasing pressure on 401K and 403(b) plans to offer index funds, and probably even some movement to make the default (401K) investment something like 50% S&P500/Total Market and 50% Total bond, or life cycle funds.

So the pool of money for active investor to manage will shrink.  Although most active managers can't outperform the market especially not by an amount that justifies their fees and expense, some can. 

In Michael Lewis, earlier book the Big Short, he talks about several investor/money manager etc. who figured out that many of the collateralized mortgage-back securities (MBS) were junk.  They made billions by creatively figuring out ways of shorting the mortgage market.  Aided in no small part by folks at Goldman Sachs and other Wall St. firms.  Now lots of people get understandable upset about shorts making billions off of the misfortune of others.  However, we can actually need more people not less question conventional wisdom, small caps out perform large caps, stocks outperform bonds,the market is or is not in a bubble.  Housing prices are too cheap or too expensive.

I suspect that are will always be healthy dose of skeptics and folks who think they are right and the rest of the market is dead wrong, and are willing to back their beliefs up with money.  The systemic danger to the stock market is that everyone will be so convinced that indexing is superior, that not enough people will be willing to turn their money over to the smart skeptics..

It is impossible to state for certain what would have happened if the guys in the Big Short, had just been folks with million portfolios and not a billion in some cases.  But certainly one possibility is that MBS's  could have continue  to go up another year or two and then crash even faster and harder. Doing more damage to the system.

How is that a systemic danger? What will happen if more and more people index and don't turn their money to smart skeptics?

DaKini

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Re: As more people index in index funds
« Reply #54 on: May 01, 2014, 07:02:11 AM »
More and more profitably arbitrage opportunitys will not be used. This will be detected and exploited by active traders, so it will never come to the point where dangerously few people will do active trading. I think there is some kind of autobalance built into the system.

arebelspy

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Re: As more people index in index funds
« Reply #55 on: May 01, 2014, 07:57:18 AM »
More and more profitably arbitrage opportunitys will not be used. This will be detected and exploited by active traders, so it will never come to the point where dangerously few people will do active trading. I think there is some kind of autobalance built into the system.

(Emphasis added.)

Some sort of invisible hand maybe?

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clifp

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Re: As more people index in index funds
« Reply #56 on: May 02, 2014, 06:35:28 AM »


How is that a systemic danger? What will happen if more and more people index and don't turn their money to smart skeptics?
Imagine that tomorrow that two things happened.
1. Tesla and Neflix were added to the S&P
2. All active money manager became indexers except for Tesla and Netflix bulls, these bulls each had 1 trillion dollars under management.

So everyday they gradually sell other stocks and bid up the price of Netflix and Tesla until eventually Netflix is trading for $165,000 , and Tesla tops $80,000 (or a trillion market cap each)

Then one day a SpaceX rocket carrying Elon Musk, crashes into the Netflix headquarters killing everyone. At which point a few doubting Thomas suggests that perhaps the stocks are wee bit over valued and even some indexer  start selling.

Do you think this would end well?

matchewed

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Re: As more people index in index funds
« Reply #57 on: May 02, 2014, 06:43:30 AM »


How is that a systemic danger? What will happen if more and more people index and don't turn their money to smart skeptics?
Imagine that tomorrow that two things happened.
1. Tesla and Neflix were added to the S&P
2. All active money manager became indexers except for Tesla and Netflix bulls, these bulls each had 1 trillion dollars under management.

So everyday they gradually sell other stocks and bid up the price of Netflix and Tesla until eventually Netflix is trading for $165,000 , and Tesla tops $80,000 (or a trillion market cap each)

Then one day a SpaceX rocket carrying Elon Musk, crashes into the Netflix headquarters killing everyone. At which point a few doubting Thomas suggests that perhaps the stocks are wee bit over valued and even some indexer  start selling.

Do you think this would end well?

Wow. I know people on this board like to use the term straw man argument when it isn't one but... that is one hell of a straw man argument.

So your systemic danger you're outlining is that if "enough" people (whatever that means) get into index funds and no one but bulls remain for a few select stocks (which can't happen as there won't be a world without people willing to bet against other people) those stocks will inflate and if something terrible happens tanking those two stocks those aforementioned bulls lose their shirts?

So? The index fund people will still only be inconvenienced as there is no way that only two stocks would inflate so much to tank an entire market. It will shake up a market certainly but it would still recover in a couple of years.

That isn't a systemic risk due to index fund investing and most of the assumptions you've placed in your example are ludicrous and unrealistic.

warfreak2

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Re: As more people index in index funds
« Reply #58 on: May 02, 2014, 07:07:05 AM »
Imagine that tomorrow that two things happened.
What you describe sounds like illegal market manipulation.

clifp

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Re: As more people index in index funds
« Reply #59 on: May 02, 2014, 07:06:19 PM »
I clearly stated my hypothesis in the post before.

Quote
I suspect that are will always be healthy dose of skeptics and folks who think they are right and the rest of the market is dead wrong, and are willing to back their beliefs up with money.  The systemic danger to the stock market is that everyone will be so convinced that indexing is superior, that not enough people will be willing to turn their money over to the smart skeptics..

You asked me what the problem would be.  It is pretty common to look at extreme cases to understand how a system might fail, for either financial engineer or real engineering.

Do you think there might be a problem if everyone indexed or do you think everything would be just swell?

matchewed

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Re: As more people index in index funds
« Reply #60 on: May 03, 2014, 07:21:05 AM »
I clearly stated my hypothesis in the post before.

Quote
I suspect that are will always be healthy dose of skeptics and folks who think they are right and the rest of the market is dead wrong, and are willing to back their beliefs up with money.  The systemic danger to the stock market is that everyone will be so convinced that indexing is superior, that not enough people will be willing to turn their money over to the smart skeptics..

You asked me what the problem would be.  It is pretty common to look at extreme cases to understand how a system might fail, for either financial engineer or real engineering.

Do you think there might be a problem if everyone indexed or do you think everything would be just swell?

As I've stated earlier in the thread everyone indexing is just as ludicrous as your extreme example. I know hyperbole is an often used form of rhetoric but it is extremely silly sounding and detracts from what I think your main point is. Could you rephrase your concern? What is the systemic risk with more people going to index funds given that there will still be other sources of active investors?

If you're going to start with extreme and frankly silly assumptions of course you will get extreme silly answers.

Also maybe try addressing my points beyond "duck season."

clifp

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Re: As more people index in index funds
« Reply #61 on: May 03, 2014, 06:11:05 PM »

As I've stated earlier in the thread everyone indexing is just as ludicrous as your extreme example. I know hyperbole is an often used form of rhetoric but it is extremely silly sounding and detracts from what I think your main point is. Could you rephrase your concern? What is the systemic risk with more people going to index funds given that there will still be other sources of active investors?

If you're going to start with extreme and frankly silly assumptions of course you will get extreme silly answers.

Also maybe try addressing my points beyond "duck season."

I don't how much clearer I can state it.  It isn't the number of active investors, it is the amount of money the active investor control that is the danger. There exists some tipping point when 50%,75%, 95% of all money is indexed or psuedo indexed (DFA, many pension fund managers) which risks bubble in either the individual components of the index or the market as a whole..

The world's financial system came perilously close to a complete meltdown, in no small part because way way too many people, who control too much money, blindly believe that if Moodys, or Standard&Poor said a security was AAA rated, they couldn't lose money.

Charles McKay's classic book Extraordinary Popular Delusions and the Madness of Crowds points out the danger of sheep like investing better than I could.

Now how about you actually answer my question.

Do you think there might be a problem if [almost] everyone indexed or do you think everything would be just swell?




Leisured

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Re: As more people index in index funds
« Reply #62 on: May 04, 2014, 01:51:02 AM »
I asked a similar question in July 2013. Here is the thread:

http://forum.mrmoneymustache.com/investor-alley/what-if-nearly-everybody-used-index-funds/msg109022/#msg109022

and this is what I wrote after having the misunderstanding explained to me:
"Thankyou cjottowa and arebelspy. I had not thought far enough ahead, so if most investors were in index funds, stock prices would become rather arbitrary because of index fund rebalancing, so active traders would correct the mispricing."



matchewed

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Re: As more people index in index funds
« Reply #63 on: May 04, 2014, 06:59:40 AM »

As I've stated earlier in the thread everyone indexing is just as ludicrous as your extreme example. I know hyperbole is an often used form of rhetoric but it is extremely silly sounding and detracts from what I think your main point is. Could you rephrase your concern? What is the systemic risk with more people going to index funds given that there will still be other sources of active investors?

If you're going to start with extreme and frankly silly assumptions of course you will get extreme silly answers.

Also maybe try addressing my points beyond "duck season."

I don't how much clearer I can state it.  It isn't the number of active investors, it is the amount of money the active investor control that is the danger. There exists some tipping point when 50%,75%, 95% of all money is indexed or psuedo indexed (DFA, many pension fund managers) which risks bubble in either the individual components of the index or the market as a whole..

The world's financial system came perilously close to a complete meltdown, in no small part because way way too many people, who control too much money, blindly believe that if Moodys, or Standard&Poor said a security was AAA rated, they couldn't lose money.

Charles McKay's classic book Extraordinary Popular Delusions and the Madness of Crowds points out the danger of sheep like investing better than I could.

Now how about you actually answer my question.

Do you think there might be a problem if [almost] everyone indexed or do you think everything would be just swell?

No it won't be a problem because it is impossible for the reason I mentioned in my first response to this thread. Just in case you didn't read it before I'll re post it.

http://forum.mrmoneymustache.com/investor-alley/stock-value-with-a-negative-eps/msg273124/#msg273124

Grant has put it best. But in short no as more people use index funds the market does not disappear.

To address the rest of what you are saying - what do you mean the winners find themselves overvalued? And how does indexing make advantages for active investors, what are they going to understand? And what do you mean by a market force, it's a passive index that reflects the actions of a market after the actions have been made, how will that change the market?

This is why I think the question in of itself is absurd. There is no way the entire market can be all index funds. The question of what happens if everyone or almost are in index funds is the same as asking how many angels can do the Hopak on the head of a pin. There will be an equillibrium where people who are comfortable with market level returns will be happy with their low cost index funds and well everyone else. People who day trade, have been convinced that whatever actively managed they invest in will outperform the market, people who receive individual stocks as compensation, people who don't know what they're doing and picked a fund because of a graph...etc, those are the doorstop for your scenario.

Also comparing it to the 2008 financial crisis is bad comparison IMO. There is a difference between financial institutions buying and selling risky investments as safe and people putting their money into index funds knowing that they will receive market returns whether that market is up or down at any particular time. I'll have to check the book out sometime.

But if we're going to entertain the absurd I've also bolded a section of what you said. How does this happen? You've made the claim that a bubble is possible when a large percentage of assets, somewhere between 50%-95%, are in index funds. How? Maybe there is something that I'm not understanding here but I just see an "If this then that" statement with nothing connecting the this and that, or in other words "duck season", or index funds bad because bubble. Are you saying that active investors will have too much influence on the market if more people go to index funds? If so how is their influence getting any more or less than it is now? As DaKini put it the market will do what it will whether a percentage of it is in index or what that percentage is. Bubbles will happen and will pop with or without index funds and index funds will just sit there and take in market returns with no direct influence on the market.

If the answer to index funds bad because of active investors then it is not because of index funds but because of active, right?

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Re: As more people index in index funds
« Reply #64 on: May 04, 2014, 07:16:48 AM »
I agree with matchewed on this.  Remember that middle-class people are the ones buying the index funds but wealthy people often invest directly with hedge funds or even their own asset management team.  They do this for a variety of reasons (and I don't claim to be an expert here) but I think it's mainly asset diversification.  Basically at that financial level it's easier to invest in things like farm-land,timber,real-estate,private equity where your options are more limited for an individual investor.  In order to justify their fees, these guys are generally not going to put their equity allocation into index funds.   It is kind of funny because in aggregate these guys don't beat the indexes so in this case the middle-class are perhaps smarter than the wealthy.

hodedofome

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Re: As more people index in index funds
« Reply #65 on: May 04, 2014, 01:15:25 PM »
Though I don't have the data in front of me there are more and more wealthy folks jumping on the index train. They too are tired of paying managers a lot of money and underperforming indexes like the S&P500.

I think most people will not be able to change their nature enough to STICK with a buy and hold index fund strategy. In the end they control their account and will buy in at the wrong time and sell at the wrong time just like they've always done. Human nature doesn't go away easily.

clifp

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Re: As more people index in index funds
« Reply #66 on: May 04, 2014, 05:20:26 PM »


But if we're going to entertain the absurd I've also bolded a section of what you said. How does this happen? You've made the claim that a bubble is possible when a large percentage of assets, somewhere between 50%-95%, are in index funds. How? Maybe there is something that I'm not understanding here but I just see an "If this then that" statement with nothing connecting the this and that, or in other words "duck season", or index funds bad because bubble. Are you saying that active investors will have too much influence on the market if more people go to index funds? If so how is their influence getting any more or less than it is now? As DaKini put it the market will do what it will whether a percentage of it is in index or what that percentage is. Bubbles will happen and will pop with or without index funds and index funds will just sit there and take in market returns with no direct influence on the market.

If the answer to index funds bad because of active investors then it is not because of index funds but because of active, right?
As said in my first post this isn't a problem now, it maybe a potential problem in the future.  The superior returns of index have been known since I started investing in early 80s. Heck I remember reading an article by financial writer Andrew Tobias about indexing in Playboy of all places  around 1983  But by 2003 indexing still hadn't caught on this Morningstar article has 12% total asset 15% equity in 2013. http://ibd.morningstar.com/article/article.asp?id=624328&CN=brf295,http://ibd.morningstar.com/archive/archive.asp?inputs=days=14;frmtId=12,%20brf295.  By 2013 33% of equity assets were indexed, if we continue this 2%/year growth in 9 years it will be a majority and by 2034 it will be  75%. Now it is true that hedge funds are active investors.  However, pension funds for the most part are more concerned with AA, and are pretty much closest indexer.  I'm on the investment committee for a pretty large non-profit and the  the domestic equity returns of our $8 million 60/40 endowment portfolio were within .5% of VTSAX last almost as close each of the last five years.  When the older guys on the committee leave, I think I'll be able to move the funds to indexing.  This is happening in my other areas of money management.

The more knowledgeable participants in market the more likely the prices are going to be accurate. A used car dealer is much less likely to get a great bargain at a auto auction bidding against a 100 other dealers than he is dealing one on one with 80 year old widow. If 67% of the market is today actively managed and that number drops 25%. It probably won't matter for valuing Apple, vs Google, vs Coke vs Exxon.  It probably would reduce the number of folks actively evaluating Bemis vs Total System Service, and certainly will reduce companies outside of S&P 500.

I don't think you understand what happened the financial crisis it wasn't just big financial firms that bought mortgage back securities MBS, everybody from small city pension funds, to a towns in Sweden bought them.  The were packaged up and sold to everybody.  This box of mortgage is rated AAA it has 5% yield and .2% off them will stop paying over the next 10 years.  This Box is rate A it has 7% yield and 1% default rate. Conceptually this is no different than saying buy this security is called SPY it has an average return of 9% and standard deviation of 15%  and this one VTI has an average return of 10% and SD of 17% and VWO has 12% return and 22% standard deviation.  There were virtually no one looking inside the MBS blackbox and evaluating the individual mortgages to make sure they were fairly priced and the sum of the components was the worth the sum of the whole thing.  Instead they were evaluated algorithmically and the algorithms were wrong.

Now we are long way from a tipping point, and perhaps will never get there.  But I do think we have reached a critical point in that there many people have become converts to indexing (I don't blame them I advise indexing for anybody elses money.) I think we well see a majority of the money be indexed soon. I also don't see indexer switching back easily even if the future active investors start beating indexing.

arebelspy

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Re: As more people index in index funds
« Reply #67 on: May 04, 2014, 05:42:52 PM »
Heck I remember reading an article by financial writer Andrew Tobias about indexing in Playboy of all places  around 1983

I wasn't aware anyone actually read those things for the articles. ;)
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clifp

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Re: As more people index in index funds
« Reply #68 on: May 04, 2014, 09:28:10 PM »
Well that wasn't the main reason I bought Playboys but they actually use to have  decent articles and also a much wider circulation before the internet arrived and made porn (both financial and regular) widely available. :-)

matchewed

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Re: As more people index in index funds
« Reply #69 on: May 05, 2014, 05:52:29 AM »

But if we're going to entertain the absurd I've also bolded a section of what you said. How does this happen? You've made the claim that a bubble is possible when a large percentage of assets, somewhere between 50%-95%, are in index funds. How? Maybe there is something that I'm not understanding here but I just see an "If this then that" statement with nothing connecting the this and that, or in other words "duck season", or index funds bad because bubble. Are you saying that active investors will have too much influence on the market if more people go to index funds? If so how is their influence getting any more or less than it is now? As DaKini put it the market will do what it will whether a percentage of it is in index or what that percentage is. Bubbles will happen and will pop with or without index funds and index funds will just sit there and take in market returns with no direct influence on the market.

If the answer to index funds bad because of active investors then it is not because of index funds but because of active, right?
As said in my first post this isn't a problem now, it maybe a potential problem in the future.  The superior returns of index have been known since I started investing in early 80s. Heck I remember reading an article by financial writer Andrew Tobias about indexing in Playboy of all places  around 1983  But by 2003 indexing still hadn't caught on this Morningstar article has 12% total asset 15% equity in 2013. http://ibd.morningstar.com/article/article.asp?id=624328&CN=brf295,http://ibd.morningstar.com/archive/archive.asp?inputs=days=14;frmtId=12,%20brf295.  By 2013 33% of equity assets were indexed, if we continue this 2%/year growth in 9 years it will be a majority and by 2034 it will be  75%. Now it is true that hedge funds are active investors.  However, pension funds for the most part are more concerned with AA, and are pretty much closest indexer.  I'm on the investment committee for a pretty large non-profit and the  the domestic equity returns of our $8 million 60/40 endowment portfolio were within .5% of VTSAX last almost as close each of the last five years.  When the older guys on the committee leave, I think I'll be able to move the funds to indexing.  This is happening in my other areas of money management.

The more knowledgeable participants in market the more likely the prices are going to be accurate. A used car dealer is much less likely to get a great bargain at a auto auction bidding against a 100 other dealers than he is dealing one on one with 80 year old widow. If 67% of the market is today actively managed and that number drops 25%. It probably won't matter for valuing Apple, vs Google, vs Coke vs Exxon.  It probably would reduce the number of folks actively evaluating Bemis vs Total System Service, and certainly will reduce companies outside of S&P 500.

That's great but now you have to determine if the actual number of active participants is getting smaller. We can determine that more folks are passively investing but that does not necessarily mean that the number of active investors is getting smaller. If your claim that having more knowledgeable participants in the market makes for better pricing and having fewer makes for less accurate pricing you'll need to determine if there are less knowledgeable participants not that there are more passive. The pool of people investing in the market isn't some static number that can only be cut one way or another.

I don't think you understand what happened the financial crisis it wasn't just big financial firms that bought mortgage back securities MBS, everybody from small city pension funds, to a towns in Sweden bought them.  The were packaged up and sold to everybody.  This box of mortgage is rated AAA it has 5% yield and .2% off them will stop paying over the next 10 years.  This Box is rate A it has 7% yield and 1% default rate. Conceptually this is no different than saying buy this security is called SPY it has an average return of 9% and standard deviation of 15%  and this one VTI has an average return of 10% and SD of 17% and VWO has 12% return and 22% standard deviation.  There were virtually no one looking inside the MBS blackbox and evaluating the individual mortgages to make sure they were fairly priced and the sum of the components was the worth the sum of the whole thing.  Instead they were evaluated algorithmically and the algorithms were wrong.

What you just said is a nuanced way to say what I said. Entities sold investments that were labeled as safe and they weren't. I don't really want to get into the 2008 financial crisis because it's irrelevant, since the only reason you've brought it up to begin with was to use it as a comparison to what would happen if more and more people use index funds and there was nothing linking the two. It was used a scare tactic common in rhetoric, a sort of ghosts of the past as there is no connection between index funds and the 2008 financial crisis.

Now we are long way from a tipping point, and perhaps will never get there.  But I do think we have reached a critical point in that there many people have become converts to indexing (I don't blame them I advise indexing for anybody elses money.) I think we well see a majority of the money be indexed soon. I also don't see indexer switching back easily even if the future active investors start beating indexing.

But you're not answering my question. How do the mechanics of index funds generate this tipping point? How does the tipping point work? What exactly happens if more and more people use index funds? And answering bubble and walking away is not an answer but a guess.

clifp

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Re: As more people index in index funds
« Reply #70 on: May 05, 2014, 03:46:02 PM »

That's great but now you have to determine if the actual number of active participants is getting smaller. We can determine that more folks are passively investing but that does not necessarily mean that the number of active investors is getting smaller. If your claim that having more knowledgeable participants in the market makes for better pricing and having fewer makes for less accurate pricing you'll need to determine if there are less knowledgeable participants not that there are more passive. The pool of people investing in the market isn't some static number that can only be cut one way or another.


No what I said is that there probably will still be a large number of active participants, but they will control less money and hence have less of ability to affect markets price. Index fund will still trade among themselves.  Joe may have keen insights on automotive industry which allows him to make good money but if only starts with $100,000 he isn't going to have much influence on the market compared to Fidelity total market fund and Vanguard Total Market fund  trading GM, or TSLA .  Joe decides he wants to get into in the money management business today he can compete for the 67% of money but if 75% of the money is indexed he is going to competing for the remaining 25%.


Quote
What you just said is a nuanced way to say what I said. Entities sold investments that were labeled as safe and they weren't. I don't really want to get into the 2008 financial crisis because it's irrelevant, since the only reason you've brought it up to begin with was to use it as a comparison to what would happen if more and more people use index funds and there was nothing linking the two. It was used a scare tactic common in rhetoric, a sort of ghosts of the past as there is no connection between index funds and the 2008 financial crisis.


But you're not answering my question. How do the mechanics of index funds generate this tipping point? How does the tipping point work? What exactly happens if more and more people use index funds? And answering bubble and walking away is not an answer but a guess.

No you are missing the point entities were trading mortgage back securities that were badly mispriced. When evidence of this overvaluation become more obvious to more participant prices quickly crashed, and caused a huge amount of collateral damage.  The root cause was because not enough people were evaluating the individual mortgage inside the securities.  The reason there weren't enough people doing this is because people trusted the rating agency that AAA mortgage backed security would behave just like any other AAA rated security.

VTI today closed at $97.64 why is it worth that price?  Do you think it is because the last folks who traded VTI, carefully got out their spreadsheet plugged in all the price of 3692 securities that it holds, multiply the price by the number of shares, and divided by the total number of shares outstanding or do you think it was simple a bid and ask transaction?

We are dependent on traders armed with computers to calculate on any given second keep the price of VTI vs all of appropriately weighted component aligned to within tenths of a percent.
We are also dependent on small smart guys pouring over VTI 10K listing, and double checking that Vanguard algorithm for market weighting the index, calculating NAV etc. are all correct. It is better to have more of these folks looking than not and money acts as a big incentive.

I never said the index fund mechanics were going cause the problems.  (It is possible that there might be bug in Vanguard computer program that says overstates the NAV and that would be a bigger issue if VTSMX was trillion dollar fund instead of a 330 billion but that is just a size thing).  My concern is the ratio of active investors to passive investor,  I think I showed at the extreme if there are only a few active investor and they are delusional (Tesla, Netflix) that would be a bad thing.  All bubbles are different, so it is pretty pointless for me to make prediction.  But during a crash, it is clear that the indiscriminate selling by index funds will make the situation worse.  Most years ~75% index funds out perform active managers, but during 2008 active managers outperformed the index fund, in no small part because index funds were forced to sell everything (even companies little effected by the financial crisis) to handle redemption.

TL:DR More smart active participants in a market are good thing, because it leads to more accurate pricing.  As the ratio of smart money to dumb money decreases it increase the chance of a bubble.  This isn't something we need to worry about for quite sometime and possibly never.

matchewed

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Re: As more people index in index funds
« Reply #71 on: May 06, 2014, 06:29:59 AM »
So your point is that an index fund which just captures the actions that have happened over the previous eight hours. Those actions which are dictated by active investors. Is vulnerable to inaccurate pricing because why again?

The ratio doesn't matter because those passive investors in the index fund never get to influence the market directly. That's why I'm asking for the mechanics on how this bubble will form. It does matter because I think you don't seem to get that the index fund is just a reactive device. Company A goes up? It buys a bit more. Company C falls so low it drops out of the criteria it sells all of it and redistributes accordingly. It is just a simple passive and reactive investment device. There is no dumb money in it because it doesn't make a choice it just reacts to circumstance.

clifp

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Re: As more people index in index funds
« Reply #72 on: May 07, 2014, 01:02:13 AM »
So your point is that an index fund which just captures the actions that have happened over the previous eight hours. Those actions which are dictated by active investors. Is vulnerable to inaccurate pricing because why again?

The ratio doesn't matter because those passive investors in the index fund never get to influence the market directly. That's why I'm asking for the mechanics on how this bubble will form. It does matter because I think you don't seem to get that the index fund is just a reactive device. Company A goes up? It buys a bit more. Company C falls so low it drops out of the criteria it sells all of it and redistributes accordingly. It is just a simple passive and reactive investment device. There is no dumb money in it because it doesn't make a choice it just reacts to circumstance.

Some financial crisis hits crisis, say insurance companies have been cooking the book don't have enough money to pay claims, but it doesn't matter it could be anything.
The market starts going down.  Nervous individual investors, start selling their index funds, so do pension fund managers.   If index funds are 75% of the market. Who in the hell is doing the buying? We start seeing days were all 500 S&P stocks are down.  As the market goes down, more and more people panic and more index fund selling occurs.  Then margin calls start being issued, now the active investor who were the buyers earlier no longer have money.  Who are the buyers now?


matchewed

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Re: As more people index in index funds
« Reply #73 on: May 07, 2014, 05:22:11 AM »
So your point is that an index fund which just captures the actions that have happened over the previous eight hours. Those actions which are dictated by active investors. Is vulnerable to inaccurate pricing because why again?

The ratio doesn't matter because those passive investors in the index fund never get to influence the market directly. That's why I'm asking for the mechanics on how this bubble will form. It does matter because I think you don't seem to get that the index fund is just a reactive device. Company A goes up? It buys a bit more. Company C falls so low it drops out of the criteria it sells all of it and redistributes accordingly. It is just a simple passive and reactive investment device. There is no dumb money in it because it doesn't make a choice it just reacts to circumstance.

Some financial crisis hits crisis, say insurance companies have been cooking the book don't have enough money to pay claims, but it doesn't matter it could be anything.
The market starts going down.  Nervous individual investors, start selling their index funds, so do pension fund managers.   If index funds are 75% of the market. Who in the hell is doing the buying? We start seeing days were all 500 S&P stocks are down.  As the market goes down, more and more people panic and more index fund selling occurs.  Then margin calls start being issued, now the active investor who were the buyers earlier no longer have money.  Who are the buyers now?

The same people who would do the buying today. Just because someone owns index funds doesn't automatically make them a stupid investor and sell at the bottom.

Your same proposal works for any kind of investing. Why is index fund investing the special circumstance?

the fixer

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Re: As more people index in index funds
« Reply #74 on: May 07, 2014, 11:46:43 AM »
The market starts going down.  Nervous individual investors, start selling their index funds, so do pension fund managers.   If index funds are 75% of the market. Who in the hell is doing the buying? We start seeing days were all 500 S&P stocks are down.  As the market goes down, more and more people panic and more index fund selling occurs.  Then margin calls start being issued, now the active investor who were the buyers earlier no longer have money.  Who are the buyers now?
Basic microeconomics. Demand has dropped, supply is up, so price will fall until supply meets demand, and every share being sold has a buyer. If index funds make up too large a portion of the market and don't have the cash to buy, other investors will snatch up the deals because they'd be just that good.

clifp

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Re: As more people index in index funds
« Reply #75 on: May 07, 2014, 05:21:49 PM »
I am done with thread, because as I said at the beginning this is theoretical problem not a real one for many years.
However, I do wonder if you folks were actually watching the markets in late 2008, and early 2009.  There were amazing bargains, but it didn't stop the stocks from continuing to go down, and down.  Same thing is true for the real estate market, amazing bargain in places like Vegas, Florida and even parts of California but it didn't matter, the herd mentality took over a people were running for the exits.

matchewed

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Re: As more people index in index funds
« Reply #76 on: May 08, 2014, 09:19:47 AM »
Hand wavy theoretical problem that can't be explained. Gotcha.

Yes lots of people were paying attention to the recession. arebelspy was probably snapping up real estate left and right, some people were selling, some people were buying much like any time. Yes lots more people were probably selling but none of this is because of index funds and I still don't get the connection.

hodedofome

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Re: As more people index in index funds
« Reply #77 on: May 10, 2014, 06:42:17 PM »
Read this today and thought of this thread. Obviously they are a little biased but still good thoughts http://www.robeco.com/images/the-dark-side-of-passive-investing-february-2014.pdf

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matchewed

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Re: As more people index in index funds
« Reply #79 on: May 12, 2014, 10:07:12 AM »
I'll agree with his first part that index funds have the side effect of treating a market as a whole singular entity rather than a collection of stocks.

I believe his second part is exactly what we were already discussing, namely that if everyone invested in index funds there would be no active investors. But it's an impossible scenario in my mind and has nothing to do with the concept of if more people invest in index funds. It seems to be an argument mainly constructed from ye ol' "if you take it to the logical extreme it breaks" philosophy. So do many things that don't break.

As for the last part I think Vanguard has a good paper on it.

But I've already stood on my soapbox for this topic.