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Learning, Sharing, and Teaching => Investor Alley => Topic started by: hatersgonnahate on April 25, 2014, 12:21:11 PM

Title: As more people index in index funds
Post by: hatersgonnahate on April 25, 2014, 12:21:11 PM
It seems like it is just money thrown to the stars, becoming a force in of itself in the market with no real risk/goal/meaning. Who is going to drive the market as more people invest in indices? If you are investing in something, you are predicting future gains, and this could be backed up by your own analysis, knowledge, supposition, etc. It just seems like index investing is "putting money out there" while letting other people take the risks. But if more and more people invest in index funds, what would happen to the market? The winners would find themselves overvalued and once you break into the index you would get a boost of money? It would be easy for any active investor to understand the nature of index funds and account for the flood of money in their stock analysis that is predetermined by a simple formula, especially if it becomes a large market force in of itself.
Title: Re: As more people index in index funds
Post by: matchewed on April 25, 2014, 12:28:08 PM
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?
Title: Re: As more people index in index funds
Post by: hatersgonnahate on April 25, 2014, 12:51:49 PM
OK so an index represents the top valued companies in an index. Say you have an index of the top five energy companies. Your total assets are 10 in this market, the actively managed guys also have 10, and others have 10.

Every now and then, a company breaks out of the five or beaks into the five. Your fund automatically buys and sells these companies when they do.

But the actively managed fund people don't like that and they know exactly when your fund is going to buy and when it is going to sell.

The actively managed guys know what is going on in the market and short the stocks when they are about to go down and they speculate based on the index.
Title: Re: As more people index in index funds
Post by: hatersgonnahate on April 25, 2014, 12:57:06 PM
Just an idea--why not invest in both the actively managed funds and the index within a particular sector that you know is going to grow in the future? Would this be a better strategy to "corner the market"?
Title: Re: As more people index in index funds
Post by: hatersgonnahate on April 25, 2014, 12:59:52 PM
I am a newbie to investing, I admit it.
Title: Re: As more people index in index funds
Post by: matchewed on April 25, 2014, 01:10:26 PM
OK so an index represents the top valued companies in an index. Say you have an index of the top five energy companies. Your total assets are 10 in this market, the actively managed guys also have 10, and others have 10.

Every now and then, a company breaks out of the five or beaks into the five. Your fund automatically buys and sells these companies when they do.

But the actively managed fund people don't like that and they know exactly when your fund is going to buy and when it is going to sell.

The actively managed guys know what is going on in the market and short the stocks when they are about to go down and they speculate based on the index.

No an index represents the index, whatever criteria that may be. It's doubtful someone would make an index of just 10 companies but it's possible. An index can be all of a sector such as energy, or it could be the entire market. Much like the thread here (http://forum.mrmoneymustache.com/investor-alley/index-funds-how-do-they-actually-work/) an index can be nearly anything.

How do the active managed people know when something is going to move in or out of an index. You seem to assume that active management has some sort of insider knowledge that is not already publicly available. There is little evidence that that is true. Most of the evidence points to the fact that most active managers do not outperform the market regularly and that very few do. Some certainly do, but by no means is it a large percentage. So no they don't know what is going on in the market. They're guessing based on their own metrics, criteria, and crystal ball reading as much as anyone is.

Just an idea--why not invest in both the actively managed funds and the index within a particular sector that you know is going to grow in the future? Would this be a better strategy to "corner the market"?

Probably not as "cornering the market" is a meaningless phrase.

I am a newbie to investing, I admit it.

http://jlcollinsnh.com/stock-series/

For the basics at least. Or just read the Four Pillars of Investing if you want more in depth investing knowledge.
Title: Re: As more people index in index funds
Post by: hodedofome on April 25, 2014, 02:48:21 PM
It is true that there are active investors out there that know the strategy of a certain index and front run it before the rebalance date. This is not something you'll hear index providers talk about though... :)

It's hard to say what the effects will be on the market if more and more people index. There are so many different strategies out there and so much money running in different directions, that it would be hard to imagine all the money chasing one thing. Some investors are diversified in many asset classes, some put all their money into 1 index fund. The stock and bond markets are pretty dang large so it's hard to say if they will suffer from the trader effect.
Title: Re: As more people index in index funds
Post by: matchewed on April 25, 2014, 03:04:44 PM
It is true that there are active investors out there that know the strategy of a certain index and front run it before the rebalance date. This is not something you'll hear index providers talk about though... :)

It's hard to say what the effects will be on the market if more and more people index. There are so many different strategies out there and so much money running in different directions, that it would be hard to imagine all the money chasing one thing. Some investors are diversified in many asset classes, some put all their money into 1 index fund. The stock and bond markets are pretty dang large so it's hard to say if they will suffer from the trader effect.

What do you mean front running a strategy of an index? An index has a certain criteria. Things either meet the criteria and are in the index or don't and are not in it. How does someone front run that? Unless you're talking something beyond a traditional index fund.
Title: Re: As more people index in index funds
Post by: hodedofome on April 25, 2014, 03:15:10 PM
Take the NASDAQ 100 for example. Stocks are dropped and added to that index all the time. When a stock is announced it will be added, traders can 'bid up' the stock, knowing that some very large orders will be coming in on a certain date, and then sell it to the funds that are tracking the index. This isn't something you or I could do easily, as a lot of this is done by HFT algorithms and by the time you hear about it, the HFT guys have already taken advantage of it. But it happens all the time.

Another example could be an equal weight index that rebalances annually. If you knew when they were going to be rebalancing, you could sell the stocks that have been up, buy the stocks that have been down, and front run the indexers that will be doing the same thing in a few days.
Title: Re: As more people index in index funds
Post by: clifp on April 25, 2014, 03:40:52 PM
Take the NASDAQ 100 for example. Stocks are dropped and added to that index all the time. When a stock is announced it will be added, traders can 'bid up' the stock, knowing that some very large orders will be coming in on a certain date, and then sell it to the funds that are tracking the index. This isn't something you or I could do easily, as a lot of this is done by HFT algorithms and by the time you hear about it, the HFT guys have already taken advantage of it. But it happens all the time.

Another example could be an equal weight index that rebalances annually. If you knew when they were going to be rebalancing, you could sell the stocks that have been up, buy the stocks that have been down, and front run the indexers that will be doing the same thing in a few days.

I think Micheal Lewis book Flash Boys, makes the case that index funds are front run all the time. Imagine IBM's 401K contributions are sent to Vanguard the 2nd and 4th Wed of each month, and CALPERS redemption's (to pay pension) are issues on the 28 th of each month. Its almost certain that the high frequency traders have figured these patterns out, and are front running both for Vanguards S&P 500 fund.   Increase the cost of the shares for IBM employees by a penny or so and decrease the sales price for Calpers
Title: Re: As more people index in index funds
Post by: matchewed on April 25, 2014, 04:22:03 PM
Take the NASDAQ 100 for example. Stocks are dropped and added to that index all the time. When a stock is announced it will be added, traders can 'bid up' the stock, knowing that some very large orders will be coming in on a certain date, and then sell it to the funds that are tracking the index. This isn't something you or I could do easily, as a lot of this is done by HFT algorithms and by the time you hear about it, the HFT guys have already taken advantage of it. But it happens all the time.

Another example could be an equal weight index that rebalances annually. If you knew when they were going to be rebalancing, you could sell the stocks that have been up, buy the stocks that have been down, and front run the indexers that will be doing the same thing in a few days.

Do you have concrete examples, such as an equal weight index that waits to rebalance annually? It just sounds hard to "front run" an index as an index just tracks whatever happened to its index for that day regardless of if it is HFT or some other investor deciding to buy or sell his shares. Basically isn't any action that happens in the market happening and then the index tracks whatever is happening. How exactly do you "take advantage" of essentially a measuring stick?
Title: Re: As more people index in index funds
Post by: clifp on April 25, 2014, 04:44:23 PM
Take the NASDAQ 100 for example. Stocks are dropped and added to that index all the time. When a stock is announced it will be added, traders can 'bid up' the stock, knowing that some very large orders will be coming in on a certain date, and then sell it to the funds that are tracking the index. This isn't something you or I could do easily, as a lot of this is done by HFT algorithms and by the time you hear about it, the HFT guys have already taken advantage of it. But it happens all the time.

Another example could be an equal weight index that rebalances annually. If you knew when they were going to be rebalancing, you could sell the stocks that have been up, buy the stocks that have been down, and front run the indexers that will be doing the same thing in a few days.

Do you have concrete examples, such as an equal weight index that waits to rebalance annually? It just sounds hard to "front run" an index as an index just tracks whatever happened to its index for that day regardless of if it is HFT or some other investor deciding to buy or sell his shares. Basically isn't any action that happens in the market happening and then the index tracks whatever is happening. How exactly do you "take advantage" of essentially a measuring stick?

Typically 2 or 3 stocks are added to the S&P 500 each year (actually 501 stocks today cause both class of Google shares are in the S&P 500).  The ones disappearing are typically due to a merger although sometimes bad financial/bankruptcy like GM a few years ago.  Lets say they are two new stocks ABC and DEF.  At the time of the announcement by Standard and Poor, ABC is selling for $30.00/share and DEF is $50.00 a share.  As far as the index is concerned ABC is $30.00 and DEF $50.00, but because of front running and assorted other tricks no Vanguard, Fidelity, or Schwab index fund is actually going to own the shares at 30.00 or $50.00 instead the average price might be $30.42 and $50.95

Now the index fund may have a low expense ratio say .05% but from the investors prospect the additional $.42 and $.95 they pay for the 2 shares is an additional expense. Along with the month to month cost with losing a penny or so by being front runned.
Title: Re: As more people index in index funds
Post by: the fixer on April 25, 2014, 06:08:54 PM
A good index fund can largely mitigate this problem. VTSAX is based on a much larger index of 5000 stocks. It samples the index so it's not public knowledge which companies in the index of 5000 stocks the fund trades in, and even if people figure it out there's nothing stopping the fund from switching over to sampling with different stocks for its next round of buys (in fact it would completely follow, as the original sampled stocks are no longer as reflective of the index as a whole if they've been bid up).

For sell orders, who's to say the fund itself doesn't increase its cash reserves a bit early in anticipation of a massive pension sale each month? It could also do the opposite and buy shares early if it has a good estimate of when new inflows are coming. There are a lot of very smart, well-paid people on both sides fighting over pennies on the dollar in this industry. I don't think it's possible for us as laypeople to calculate the damage done to our portfolios as a result, all we can do is determine a worst-case estimate of how bad it is.
Title: Re: As more people index in index funds
Post by: clifp on April 26, 2014, 06:02:28 AM
A good index fund can largely mitigate this problem. VTSAX is based on a much larger index of 5000 stocks. It samples the index so it's not public knowledge which companies in the index of 5000 stocks the fund trades in, and even if people figure it out there's nothing stopping the fund from switching over to sampling with different stocks for its next round of buys (in fact it would completely follow, as the original sampled stocks are no longer as reflective of the index as a whole if they've been bid up).

For sell orders, who's to say the fund itself doesn't increase its cash reserves a bit early in anticipation of a massive pension sale each month? It could also do the opposite and buy shares early if it has a good estimate of when new inflows are coming. There are a lot of very smart, well-paid people on both sides fighting over pennies on the dollar in this industry. I don't think it's possible for us as laypeople to calculate the damage done to our portfolios as a result, all we can do is determine a worst-case estimate of how bad it is.

I mostly agree it is difficult task. However, something to consider. Michael Lewis and other (including Charles Schwab and the Schwab's CEO) have all been saying the high frequency have are making billions with most common estimate being $10-20/billion per year. If you figure that market capitalization of the US stock market is roughly $20 trillion a year than $10 billion is the equivalent of .05%, which doesn't seem like much until you consider that expense ratio of a Vanguard, Schwab, or Fidelity Index fund or ETF are also .05% so the traders are basically doubling the cost of owning an index fund.
Title: Re: As more people index in index funds
Post by: hodedofome on April 27, 2014, 06:23:39 AM
Take the NASDAQ 100 for example. Stocks are dropped and added to that index all the time. When a stock is announced it will be added, traders can 'bid up' the stock, knowing that some very large orders will be coming in on a certain date, and then sell it to the funds that are tracking the index. This isn't something you or I could do easily, as a lot of this is done by HFT algorithms and by the time you hear about it, the HFT guys have already taken advantage of it. But it happens all the time.

Another example could be an equal weight index that rebalances annually. If you knew when they were going to be rebalancing, you could sell the stocks that have been up, buy the stocks that have been down, and front run the indexers that will be doing the same thing in a few days.

Do you have concrete examples, such as an equal weight index that waits to rebalance annually? It just sounds hard to "front run" an index as an index just tracks whatever happened to its index for that day regardless of if it is HFT or some other investor deciding to buy or sell his shares. Basically isn't any action that happens in the market happening and then the index tracks whatever is happening. How exactly do you "take advantage" of essentially a measuring stick?

A quick Google search of front running etf rebalance date will give you plenty of reading material. It is well known in the trading world.
Title: Re: As more people index in index funds
Post by: matchewed on April 27, 2014, 08:02:17 AM
So we're no longer talking about an index fund but an ETF then?

If so we're just moving the goal posts.
Title: Re: As more people index in index funds
Post by: the fixer on April 27, 2014, 02:59:49 PM
If you figure that market capitalization of the US stock market is roughly $20 trillion a year than $10 billion is the equivalent of .05%, which doesn't seem like much until you consider that expense ratio of a Vanguard, Schwab, or Fidelity Index fund or ETF are also .05% so the traders are basically doubling the cost of owning an index fund.
That would be an average across all HFT activity, only a portion of which would be directed at index funds (the rest would  be taking advantage of other large institutional investors). Of the portion affecting index funds, most of that is going to be affecting the funds backing the most popular indices: mainly the S&P500. VTSAX is a gigantic fund and would be a lucrative target for HFT, but I doubt it gets hit with an average or higher share of the HFT hit in context of the other fish on the radar.

So let's say it's .03%, or $30 per $100k invested. If that's the case, why is it worth even talking about?
Title: Re: As more people index in index funds
Post by: hodedofome on April 27, 2014, 03:57:13 PM
So we're no longer talking about an index fund but an ETF then?

If so we're just moving the goal posts.

Index fund/ETF/Mutual fund, whatever you want to call it, doesn't matter. If you really care, there's plenty of research out there to find with basic google searches. I'm not going to spend a bunch of time doing everyone's work for them.
Title: Re: As more people index in index funds
Post by: matchewed on April 27, 2014, 04:56:34 PM
So we're no longer talking about an index fund but an ETF then?

If so we're just moving the goal posts.

Index fund/ETF/Mutual fund, whatever you want to call it, doesn't matter. If you really care, there's plenty of research out there to find with basic google searches. I'm not going to spend a bunch of time doing everyone's work for them.

Ah that strategy. Look no offense but if you're going to make a claim and then take the lazy way out when someone questions it maybe you shouldn't make the claim. It stifles the conversation. Also the topic being discussed was about what happens if everyone moves to index investing.

You've made the claim that active investors are "front running" passive indices which are just a reflection of whatever happened in the market. When asked for proof you cop out with a "just google it" and then try to make me out to be the lazy one? Ha.

Unsupported claims are just hot air and smoke. I think you're blowin' plenty of both at this point.

Title: Re: As more people index in index funds
Post by: clifp on April 27, 2014, 07:44:54 PM
If you figure that market capitalization of the US stock market is roughly $20 trillion a year than $10 billion is the equivalent of .05%, which doesn't seem like much until you consider that expense ratio of a Vanguard, Schwab, or Fidelity Index fund or ETF are also .05% so the traders are basically doubling the cost of owning an index fund.
That would be an average across all HFT activity, only a portion of which would be directed at index funds (the rest would  be taking advantage of other large institutional investors). Of the portion affecting index funds, most of that is going to be affecting the funds backing the most popular indices: mainly the S&P500. VTSAX is a gigantic fund and would be a lucrative target for HFT, but I doubt it gets hit with an average or higher share of the HFT hit in context of the other fish on the radar.

So let's say it's .03%, or $30 per $100k invested. If that's the case, why is it worth even talking about?

The $10-20 billion cost is spread out across all market participant. I see no reason to think that  Vanguard wouldn't be hit at least is much as average so I'll stick with the .05% figure
Expenses matter and its shame to give the profits to HF traders as opposed to the Vanguards, Schwab, and Fidelity that have worked hard to lower expense for average investors.

The difference between $100,000 earning the stock market average of 9% over 40 years, and 100,000 earning 9.05% over 40 years is >$58,000 still want to argue its nothing?
Title: Re: As more people index in index funds
Post by: DaKini on April 28, 2014, 03:35:48 AM
But doesn't front running also alter my already established positions in a fund?
And why is that a problem? Should this not flat out over a longer period of time?
Title: Re: As more people index in index funds
Post by: grantmeaname on April 28, 2014, 05:07:07 AM
The $10-20 billion cost is spread out across all market participant. I see no reason to think that  Vanguard wouldn't be hit at least is much as average so I'll stick with the .05% figure
You still haven't explained how an index like VTSAX is possible to front-run. There's no announced list of trades, just a portfolio that is as close to statistically equivalent to the market as possible without holding more than 20% of the securities or so.
Title: Re: As more people index in index funds
Post by: warfreak2 on April 28, 2014, 07:36:05 AM
So we're no longer talking about an index fund but an ETF then?

If so we're just moving the goal posts.
I think the point was that if it makes a difference to you, you could change "ETF" to "index fund" in your google search, and you would find the same discussions. ETFs and index funds are not seperate categories; ETFs are just wrappers that enable investors to more conveniently buy and sell stakes in, for example, index funds. Vanguard index funds are available directly through Vanguard, and also as ETFs - either way your money is invested in the same index fund, according to the same rules defined by the index.

Quote
You still haven't explained how an index like VTSAX is possible to front-run. There's no announced list of trades, just a portfolio that is as close to statistically equivalent to the market as possible without holding more than 20% of the securities or so.
Actually, he did explain it earlier in the thread, for two examples - the NASDAQ 100 and an equal weight index. He also suggested where to find more information on the topic, but if you wanted information rather than an argument, I guess you'd have looked.

The trades may not be announced, but they can be predictable, depending on the index. For example, S&P 500 or Russell 1000 index funds each buy and sell according to a list of rules which define the index itself, and those rules are public knowledge. According to the fixer, VTSAX and many other funds have defenses against frontrunning, in the sense that the index they track does not define exactly what stocks they should hold in what proportions, but clearly this depends on the index, and the fact that they defend against it at all should be a clue that there is something to defend against.
Title: Re: As more people index in index funds
Post by: grantmeaname on April 28, 2014, 09:19:36 AM
I said "an index like VTSAX". Not "any index you want to explain", but "an index like VTSAX". I read the thread, and he has not explained how most indexes could be front-run, just two indices that are atypical of index funds on the whole. I am arguing that for VTSAX and other funds like it, that logic doesn't apply.
Title: Re: As more people index in index funds
Post by: warfreak2 on April 28, 2014, 09:55:07 AM
I said "an index like VTSAX". Not "any index you want to explain", but "an index like VTSAX". I read the thread, and he has not explained how most indexes could be front-run, just two indices that are atypical of index funds on the whole. I am arguing that for VTSAX and other funds like it, that logic doesn't apply.
Whatever the index is, the point is that a fund which tracks that index must make trades when the composition of the index changes. You appear to be arguing that it's atypical for an index to change its composition at all, but this is wrong, even for total stock market indices.
Title: Re: As more people index in index funds
Post by: hodedofome on April 28, 2014, 10:03:10 AM
So we're no longer talking about an index fund but an ETF then?

If so we're just moving the goal posts.

Index fund/ETF/Mutual fund, whatever you want to call it, doesn't matter. If you really care, there's plenty of research out there to find with basic google searches. I'm not going to spend a bunch of time doing everyone's work for them.

Ah that strategy. Look no offense but if you're going to make a claim and then take the lazy way out when someone questions it maybe you shouldn't make the claim. It stifles the conversation. Also the topic being discussed was about what happens if everyone moves to index investing.

You've made the claim that active investors are "front running" passive indices which are just a reflection of whatever happened in the market. When asked for proof you cop out with a "just google it" and then try to make me out to be the lazy one? Ha.

Unsupported claims are just hot air and smoke. I think you're blowin' plenty of both at this point.

[Mod Edit: Personal attack removed.] There's no reason for me to copy and paste easy to find research on a message board. I have much better things to do with my time. I told you where to find it. This was EASY to find, and there's plenty of additional research that is EASY to find on the topic http://seekingalpha.com/article/232654-indexings-hidden-costs

[Mod Edit: Rude comment removed.  Please read the site rules, especially rule #1: Don't be a jerk.]

You have a belief about how markets work. Somebody tells you that your belief may be wrong and then tells you where to find the answer. Instead of doing your own research and learning if your beliefs might actually be wrong, you just tell the person giving you information that if they don't provide proof you won't believe it. It seems as if you're just trying to win an argument, instead of getting to the truth. I didn't become a profitable trader by telling people I disagreed with that they were wrong. I became a profitable trader by taking the information that contradicted my beliefs, and then doing the necessary research to determine if my beliefs were right or they needed to be changed. Staying open minded and research/truth focused instead of always trying to be right, is how we grow and learn.
Title: Re: As more people index in index funds
Post by: matchewed on April 28, 2014, 11:10:40 AM
So we're no longer talking about an index fund but an ETF then?

If so we're just moving the goal posts.

Index fund/ETF/Mutual fund, whatever you want to call it, doesn't matter. If you really care, there's plenty of research out there to find with basic google searches. I'm not going to spend a bunch of time doing everyone's work for them.

Ah that strategy. Look no offense but if you're going to make a claim and then take the lazy way out when someone questions it maybe you shouldn't make the claim. It stifles the conversation. Also the topic being discussed was about what happens if everyone moves to index investing.

You've made the claim that active investors are "front running" passive indices which are just a reflection of whatever happened in the market. When asked for proof you cop out with a "just google it" and then try to make me out to be the lazy one? Ha.

Unsupported claims are just hot air and smoke. I think you're blowin' plenty of both at this point.

You are so lazy that you can't type a few words into google and read it for yourself? There's no reason for me to copy and paste easy to find research on a message board. I have much better things to do with my time. I told you where to find it. This was EASY to find, and there's plenty of additional research that is EASY to find on the topic http://seekingalpha.com/article/232654-indexings-hidden-costs

The arrogance of some people on this message board, who are just flat out ignorant of the finance world, amazes me.

You have a belief about how markets work. Somebody tells you that your belief may be wrong and then tells you where to find the answer. Instead of doing your own research and learning if your beliefs might actually be wrong, you just tell the person giving you information that if they don't provide proof you won't believe it. It seems as if you're just trying to win an argument, instead of getting to the truth. I didn't become a profitable trader by telling people I disagreed with that they were wrong. I became a profitable trader by taking the information that contradicted my beliefs, and then doing the necessary research to determine if my beliefs were right or they needed to be changed. Staying open minded and research/truth focused instead of always trying to be right, is how we grow and learn.

You are making a claim that active investors are front running. Front running is defined as taking advantage of advance knowledge. Your article states that after the announcement the stock price was driven up by trading from active investors reacting to public knowledge. That fails to meet the definition of the term you are using.

So rather than jumping on your high horse of being a profitable trader and calling me lazy for asking for proof of a claim maybe you can provide evidence that front running index funds is a thing instead of providing evidence that people react to publicly available news. Does HFT exist and do they pay for closer locations to the NYSE so that they can execute trades milliseconds before others? Yes. Is there evidence that they are getting advanced knowledge? I have yet to see that. I see that they are reacting to public news faster than a guy at a PC can because they have algorithms looking for the news and information they need to execute faster trades than others.
Title: Re: As more people index in index funds
Post by: hodedofome on April 28, 2014, 11:26:19 AM
So we're no longer talking about an index fund but an ETF then?

If so we're just moving the goal posts.

Index fund/ETF/Mutual fund, whatever you want to call it, doesn't matter. If you really care, there's plenty of research out there to find with basic google searches. I'm not going to spend a bunch of time doing everyone's work for them.

Ah that strategy. Look no offense but if you're going to make a claim and then take the lazy way out when someone questions it maybe you shouldn't make the claim. It stifles the conversation. Also the topic being discussed was about what happens if everyone moves to index investing.

You've made the claim that active investors are "front running" passive indices which are just a reflection of whatever happened in the market. When asked for proof you cop out with a "just google it" and then try to make me out to be the lazy one? Ha.

Unsupported claims are just hot air and smoke. I think you're blowin' plenty of both at this point.

You are so lazy that you can't type a few words into google and read it for yourself? There's no reason for me to copy and paste easy to find research on a message board. I have much better things to do with my time. I told you where to find it. This was EASY to find, and there's plenty of additional research that is EASY to find on the topic http://seekingalpha.com/article/232654-indexings-hidden-costs

The arrogance of some people on this message board, who are just flat out ignorant of the finance world, amazes me.

You have a belief about how markets work. Somebody tells you that your belief may be wrong and then tells you where to find the answer. Instead of doing your own research and learning if your beliefs might actually be wrong, you just tell the person giving you information that if they don't provide proof you won't believe it. It seems as if you're just trying to win an argument, instead of getting to the truth. I didn't become a profitable trader by telling people I disagreed with that they were wrong. I became a profitable trader by taking the information that contradicted my beliefs, and then doing the necessary research to determine if my beliefs were right or they needed to be changed. Staying open minded and research/truth focused instead of always trying to be right, is how we grow and learn.

You are making a claim that active investors are front running. Front running is defined as taking advantage of advance knowledge. Your article states that after the announcement the stock price was driven up by trading from active investors reacting to public knowledge. That fails to meet the definition of the term you are using.

So rather than jumping on your high horse of being a profitable trader and calling me lazy for asking for proof of a claim maybe you can provide evidence that front running index funds is a thing instead of providing evidence that people react to publicly available news. Does HFT exist and do they pay for closer locations to the NYSE so that they can execute trades milliseconds before others? Yes. Is there evidence that they are getting advanced knowledge? I have yet to see that. I see that they are reacting to public news faster than a guy at a PC can because they have algorithms looking for the news and information they need to execute faster trades than others.

I defined the term in my first example, and then you asked me for concrete examples which I provided in the article and is in the research papers listed in the article. You are the one changing the definition of the term as I originally described it.
Title: Re: As more people index in index funds
Post by: grantmeaname on April 28, 2014, 06:13:31 PM
Whatever the index is, the point is that a fund which tracks that index must make trades when the composition of the index changes. You appear to be arguing that it's atypical for an index to change its composition at all, but this is wrong, even for total stock market indices.
It's completely obvious which trade is going to happen if it's a case of firms number #501 and #500 in the S&P trading places, and I agree that there is some potential for predictability in that case - though index funds are only a small part of the investing universe and the actual dates the trades are being made are unknown, so at most the "front-running" could be a small bump to the return otherwise found from holding stock #501 or shorting stock #500 over the period. But it's not obvious at all - in fact, I'd argue it's undeterminable - what trades VTSAX or a similar mutual fund is making over a given period because 1) they don't hold every stock that's contained in their relevant index, 2) their index itself is proprietary, and 3) they share the same uncertain timing that the other mutual funds use to prevent front-running.  It's not that the index doesn't change, it's that changes in the index are unclear and changes in the fund are even more opaque.
Title: Re: As more people index in index funds
Post by: grantmeaname on April 28, 2014, 06:14:16 PM
So what's with the shrillness here in the alley lately?
Title: Re: As more people index in index funds
Post by: clifp on April 29, 2014, 01:03:55 AM
The $10-20 billion cost is spread out across all market participant. I see no reason to think that  Vanguard wouldn't be hit at least is much as average so I'll stick with the .05% figure
You still haven't explained how an index like VTSAX is possible to front-run. There's no announced list of trades, just a portfolio that is as close to statistically equivalent to the market as possible without holding more than 20% of the securities or so.

You should really read the book Flash Boys or even just Google the many interviews with the author Micheal Lewis.

In my best "24" fashion."the following transactions occurred on 4/16/2014 between 11:45:33 AM and 11:45:34 am"
this all happens in flash

VTSAX needs to buy 100,000 shares of GE stock
The current bid for GE 300,000 at $26.00 and ask 200,000 shares is 26.01

The vanguard computer puts out a limit order GE 100,000@26.01
but instead of getting 100,000 they only get 1,000
 bid 299,000 at 26.01 ask 210,000 at 26.02
new limit order GE 99,000 @26.02
This time VTSAX gets 10,000 share@26.02
bid 289,000@26.02 ask 220,000@26.03
new limit order GE 89,000@26.03
this time 20,000 shares get purchased@26.03
bid 269,000@26.03 ask 205,000@26.04
new order order GE 69,000 @26.04
Only 5,000 shares get filled
bid 264,00 @26.04 ask 300,000 @26.05
new limit order 64,000 @26.05
result
50,000 shares bought@26.049
14,000 shares @26.05

So finally VTSAX has its 100,000 shares of GE at average price of 26.042/share.

What is really going on is that 200,000 volume on both the bid and ask is fake/sham bids by high frequency traders front running traders with slower computer connections.
In reality Vanguard was the only big buyer who wanted to purchase 100,000 share and let say Fidelity wanted to sell 100,000 shares of GE along with some smaller seller. In the days before HF trading they would meet in the middle between 26.01 and 26.05 and the 100,000 share would have be exchange at $26.03,  Instead in the next second the process is going to reversed Fidelity is going sell the remaining 86,000 share and being front runned.  (They sold 14,000 shares to VTSAX) but instead of selling for 26.05 like they thought they'll probably end up selling the bulk at $26.00 costing Fidelity fund owners a penny or two.

Now you might think $.012 for 100,000 shares is only $1,200 big deal..
But when you consider that a one professor estimated there were something like 20,000 opportunities to front run  Apple EACH DAY the money adds up.
Title: Re: As more people index in index funds
Post by: grantmeaname on April 29, 2014, 06:48:18 AM
So now we're talking about HFT and not front-running.

HFT can be mitigated by direct trades with other institutional investors, trading in dark pools, and not buying the shares in the first place - which is how vanguard does much of its purchasing (https://pressroom.vanguard.com/nonindexed/6.14.2013_Understanding_Synthetic_ETFs.pdf). That's a totally different matter than front-running, and the mutual funds have their own defenses against it.
Title: Re: As more people index in index funds
Post by: arebelspy on April 29, 2014, 07:52:53 AM
I'm all on  board with HFT should be banned (well, de facto banned via a very tiny tax on each trade that eliminates its value, being my favorite method over introducing lag or anything), but we kinda got side tracked.

None of that is super relevant to what happens when more and more of the market Index.  HFT in order to front run affects every trade, not just indexing (if anything, it likely affects indexing less because most indexers are less frequent traders than those buying multiple individual stocks, or other securities).  It may, or may not, be an issue (and I lean towards it being one), but it's an issue for the market as a whole, not just index funds.
Title: Re: As more people index in index funds
Post by: aclarridge on April 29, 2014, 08:50:39 AM
None of that is super relevant to what happens when more and more of the market Index.  HFT in order to front run affects every trade, not just indexing (if anything, it likely affects indexing less because most indexers are less frequent traders than those buying multiple individual stocks, or other securities).  It may, or may not, be an issue (and I lean towards it being one), but it's an issue for the market as a whole, not just index funds.

I think the "get rich quick" or more accurately "outperform" siren song of active managers will keep people interested in active investing for as long as the capital markets exist in their current form. The best and luckiest ones will indeed outperform everybody, keeping the allure of active management intact. How could it possibly go away? It's human nature to compete to win like that.

Index investors will consistently only earn average returns, but over time that should satisfy them.
Title: Re: As more people index in index funds
Post by: aclarridge on April 29, 2014, 08:53:12 AM
I guess it would concern me if we ever got to a point where non-index investors in aggregate beat index investors in aggregate. I wonder if there is a way to check that - one would think that because of fees it shouldn't really ever happen.
Title: Re: As more people index in index funds
Post by: arebelspy on April 29, 2014, 09:03:20 AM
I guess it would concern me if we ever got to a point where non-index investors in aggregate beat index investors in aggregate. I wonder if there is a way to check that - one would think that because of fees it shouldn't really ever happen.

Yeah, mathematically can't happen, if the fees of the non-index are greater than the index.  Of course if there are no fees (say, a day trader working for themselves) it's theoretically possible, sure.
Title: Re: As more people index in index funds
Post by: clifp on April 29, 2014, 07:49:18 PM
So now we're talking about HFT and not front-running.

HFT can be mitigated by direct trades with other institutional investors, trading in dark pools, and not buying the shares in the first place - which is how vanguard does much of its purchasing (https://pressroom.vanguard.com/nonindexed/6.14.2013_Understanding_Synthetic_ETFs.pdf). That's a totally different matter than front-running, and the mutual funds have their own defenses against it.

No one of the problems (or benefits for HFT firms)  with high frequency trading is front running.  HFT isn't necessarily bad if for instance trades on things like the minor price discrepancies between SPY and the 500 individual stock prices.   Dark pools, are in many ways even worse since there is no transparency into the trades.

I agree with Arebelspy this is a bit off topic. So I'll close with Schwab's (my main brokerage) statement.

Quote
Charles Schwab Corporation Chairman Charles Schwab and President and CEO Walt Bettinger posted the following statement on high-frequency trading at: http://www.aboutschwab.com/press/issues/

High-frequency trading is a growing cancer that needs to be addressed

Schwab serves millions of investors and has been observing the development of high-frequency trading practices over the last few years with great concern. As we noted in an opinion piece in the Wall Street Journal last summer, high-frequency trading has run amok and is corrupting our capital market system by creating an unleveled playing field for individual investors and driving the wrong incentives for our commodity and equities exchanges. The primary principle behind our markets has always been that no one should carry an unfair advantage. That simple but fundamental principle is being broken.

High-frequency traders are gaming the system, reaping billions in the process and undermining investor confidence in the fairness of the markets. Itís a growing cancer and needs to be addressed. If confidence erodes further, the fuel of our free-enterprise system, capital formation, is at risk. We canít allow that to happen. For sure, we still believe investing in equities is a primary path to long-term wealth creation, and we believe in the long-term structural integrity of the markets to deliver that over time for individual investors, which is all the more reason to be vigilant in removing anything that creates unfair advantage or undermines investor confidence.
- See more at: http://pressroom.aboutschwab.com/press-release/corporate-and-financial-news/schwab-statement-high-frequency-trading#sthash.uulmKhcr.dpuf
Title: Re: As more people index in index funds
Post by: hodedofome on April 29, 2014, 10:28:28 PM
Here's a bit of the other side of the argument on the whole HFT thing http://www.mercenarytrader.com/2014/04/dumb-tourist-michael-lewis-flash-boys-review/

HFT may be bad to some people today, but it's 100x better than what we used to have.
Title: Re: As more people index in index funds
Post by: aclarridge on April 30, 2014, 06:49:52 AM
Here's a bit of the other side of the argument on the whole HFT thing http://www.mercenarytrader.com/2014/04/dumb-tourist-michael-lewis-flash-boys-review/

HFT may be bad to some people today, but it's 100x better than what we used to have.

Interesting review. I'm not sure I value liquidity as much as this guy does though. When buying things on Craigslist for example, or buying a house, you're dealing with much more illiquid markets, but patient investors usually get a good price.

I agree with him on one thing though, Lewis is definitely sensationalizing the issue and it's hurting his credibility.
Title: Re: As more people index in index funds
Post by: arebelspy on April 30, 2014, 07:42:26 AM
HFT may be bad to some people today, but it's 100x better than what we used to have.

Uh, no.  We have plenty of liquidity with the Internet without HFT.

Title: Re: As more people index in index funds
Post by: hodedofome on April 30, 2014, 07:48:23 AM
Yeah I think the key takeaway is that while HFT might not be the perfect solution, it was a lot worse when people like Goldman Sachs, Lehman Brothers, human exchange specialists/market makers and other investment banks controlled all the trading. It's now a bunch of smaller HFT firms doing what they used to do, and they are probably making less money than the big guys used to. Compared to what my grandpa had to do to invest in stocks...the fact that I can open an account with Vanguard, buy ETFs that are almost free on the expense side, with a bid/ask spread of $.01, and pay $0 commission for it, should tell you how far we've come. To say that markets are rigged...well...they've ALWAYS been rigged by the guys who control the trading execution.  When trading was done in the pits, the rigging was horrendous.
Title: Re: As more people index in index funds
Post by: hodedofome on April 30, 2014, 08:07:03 AM
HFT may be bad to some people today, but it's 100x better than what we used to have.

Uh, no.  We have plenty of liquidity with the Internet without HFT.

I don't quite understand what you're saying. How does your order get executed through internet trading without HFT? HFT is the modern market making.
Title: Re: As more people index in index funds
Post by: arebelspy on April 30, 2014, 08:15:40 AM
It seems like you are confusing "electronic trading" and "high frequency trading."
Title: Re: As more people index in index funds
Post by: hodedofome on April 30, 2014, 08:44:17 AM
Sorry, you are correct that some electronic trading happens without outside HFT firms in the mix. I use the terms interchangeably now but that's probably not correct.
Title: Re: As more people index in index funds
Post by: arebelspy on April 30, 2014, 09:06:14 AM
Sorry, you are correct that some electronic trading happens without outside HFT firms in the mix. I use the terms interchangeably now but that's probably not correct.

Of course it does.  Remember the 90s?

That's what you should be comparing to with HFT or not.  Not some comparison to what was available to your grandfather, but what was available to us just a decade ago.

HFT is not necessary for electronic trading, or liquidity.  The tiny amount of extra liquidity it provides is irrelevant and useless.
Title: Re: As more people index in index funds
Post by: Chuck on April 30, 2014, 02:07:04 PM
If index investing creates a value imbalance, investors will take advantage of it by buying the undervalued stock. Thus the cycle continues onward.
Title: Re: As more people index in index funds
Post by: warfreak2 on April 30, 2014, 02:44:58 PM
If index investing creates a value imbalance, investors will take advantage of it by buying the undervalued stock. Thus the cycle continues onward.
Put another way, the Efficient Market Hypothesis holds only because of the people who operate on the assumption that it doesn't.
Title: Re: As more people index in index funds
Post by: hatersgonnahate on April 30, 2014, 03:15:46 PM
The HFTers and the Indexers...two warring groups attempting to scoop off the top of active investors, the ones who do the grunt work and take the risk of investing in a company?
Title: Re: As more people index in index funds
Post by: clifp on April 30, 2014, 04:18:30 PM
Here's a bit of the other side of the argument on the whole HFT thing http://www.mercenarytrader.com/2014/04/dumb-tourist-michael-lewis-flash-boys-review/

HFT may be bad to some people today, but it's 100x better than what we used to have.

I read that guys blog shortly after reading the book. He obviously didn't read the book careful.  Electronic trading has been with us in various form since the 90s. The high speed high frequency trading is a relatively recent phenom 2007 or so.

HF traders provide the illusion of liquidity The actual liquidity the provide is limited to 100 shares or 1 option contract at price typical 1/10 of a penny higher or lower than the bid ask,and for a time that is measure in milliseconds at one exchange (BATS).

Its kinda of a like matador waving a cape in front of bull, suckers the animal into charging, so it can spear the animal as he steps aside. In my example they advertise there 200,000 shares GE available but you can't actual buy or sell them, unless already have another buyer or seller available they can a make profit. 

A market maker provides liquidity in exchange for taking risk he could end up with 100,000 shares of GE only to find the market moves away from him.  The HFT firms take no risk and provide no economic benefit.  (Actually negative benefit but that is a long discussion.)
Title: Re: As more people index in index funds
Post by: matchewed on April 30, 2014, 04:25:22 PM
The HFTers and the Indexers...two warring groups attempting to scoop off the top of active investors, the ones who do the grunt work and take the risk of investing in a company?

When you invest in an index fund you invest in the companies the index fund is comprised of too. So index fund investors do have the same risk. It is mitigated by investing in all the other companies.

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.
Title: Re: As more people index in index funds
Post by: warfreak2 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.
Title: Re: As more people index in index funds
Post by: matchewed 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.
Title: Re: As more people index in index funds
Post by: clifp 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.
Title: Re: As more people index in index funds
Post by: matchewed 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?
Title: Re: As more people index in index funds
Post by: DaKini 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.
Title: Re: As more people index in index funds
Post by: arebelspy 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?

(http://2x43di7fqtr1359hx1tnjj0te6.wpengine.netdna-cdn.com/wp-content/uploads/2013/12/charles-barsotti-there-there-it-is-again-the-invisible-hand-of-the-marketplace-giving-us.jpg)
Title: Re: As more people index in index funds
Post by: clifp 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?
Title: Re: As more people index in index funds
Post by: matchewed 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.
Title: Re: As more people index in index funds
Post by: warfreak2 on May 02, 2014, 07:07:05 AM
Imagine that tomorrow that two things happened.
What you describe sounds like illegal market manipulation.
Title: Re: As more people index in index funds
Post by: clifp 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?
Title: Re: As more people index in index funds
Post by: matchewed 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."
Title: Re: As more people index in index funds
Post by: clifp 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?



Title: Re: As more people index in index funds
Post by: Leisured 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."


Title: Re: As more people index in index funds
Post by: matchewed 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?
Title: Re: As more people index in index funds
Post by: bobmarley9993 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.
Title: Re: As more people index in index funds
Post by: hodedofome 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.
Title: Re: As more people index in index funds
Post by: clifp 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 (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.
Title: Re: As more people index in index funds
Post by: arebelspy 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. ;)
Title: Re: As more people index in index funds
Post by: clifp 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. :-)
Title: Re: As more people index in index funds
Post by: matchewed 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 (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.
Title: Re: As more people index in index funds
Post by: clifp 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.
Title: Re: As more people index in index funds
Post by: matchewed 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.
Title: Re: As more people index in index funds
Post by: clifp 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?

Title: Re: As more people index in index funds
Post by: matchewed 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?
Title: Re: As more people index in index funds
Post by: the fixer 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.
Title: Re: As more people index in index funds
Post by: clifp 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.
Title: Re: As more people index in index funds
Post by: matchewed 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. (http://forum.mrmoneymustache.com/investor-alley/how-did-you-react-to-the-2008-09-stock-crash/) Yes lots more people were probably selling but none of this is because of index funds and I still don't get the connection.
Title: Re: As more people index in index funds
Post by: hodedofome 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
Title: Re: As more people index in index funds
Post by: arebelspy on May 10, 2014, 08:58:53 PM
Surprised no one has mentioned Renewable Wealth's "Confessions of an Index Investing Skeptic" mini-series (4 posts so far):

http://renewablewealth.com/articles/confessions-of-an-index-investing-skeptic-introduction/

http://renewablewealth.com/articles/confessions-of-an-index-investing-skeptic-part-i-diversification-aint-what-it-used-to-be/

http://renewablewealth.com/articles/confessions-of-an-index-investing-skeptic-part-ii-gamblers-fools-and-the-efficient-market-theory/

http://renewablewealth.com/articles/confessions-of-an-index-investing-skeptic-part-iii-the-great-grey-menace/
Title: Re: As more people index in index funds
Post by: matchewed 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. (https://institutional.vanguard.com/iam/pdf/Baby_boomers_and_equity_returns.pdf)

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