Author Topic: FT article about problems with indexing and efficient markets  (Read 1285 times)

ChpBstrd

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FT article about problems with indexing and efficient markets
« on: January 02, 2020, 08:38:38 AM »
Iím skeptical of claims that passive indexing could cause price distortions, but for the sake of self-questioning I read the following article in the Financial Times. Itís one of the better critiques Iíve read.

https://www.ft.com/content/dbf88254-22af-11ea-b8a1-584213ee7b2b

It says, basically, that measuring everything in terms of performance versus an index has the following effects:

1) Asset managers whose performance is measured against capitalization weighted indices are pressured to buy more of assets/sectors with a rising price, lest their performance stray too far from their index. There is an agency problem here.

2) The mathematical impact on performance versus the benchmark is less for holding a declining asset/sector too long than it is for failing to immediately rebalance to buy more of an asset/sector that is rapidly rising.

3) Momentum investors jump on stocks as soon as an uptrend is apparent, thereby exploiting the benchmarkersí requirement to rebalance some time later when a stockís capitalization exceeds some threshold. The article implies there is some lag or threshold for index fund rebalancing that is higher than the lag or threshold for detecting a momentum trend. IMO this is the part that needs additional proof.

4) Small increases in stock prices start to snowball as momentum investors jump in, followed by index fund money. The result is a bias for higher asset prices (and I would think this forces us to conclude, more lumpy valuations, because some assets/sectors get this boost and others donít).

5) Passive investors would be better off instructing their investing agents to pursue cash flows rather than price-based strategies such as keeping up with indices.

While Iím not sold on the validity of the argument that momentum investors are consistently able to prey on index investors, the article does describe a realistic cat and mouse game between benchmarkers and momentum investors that I would expect to increase the churn of both types of funds as they try not to let the other get ahead of them. The mathematical properties of compounding create this scenario where missing out on buying assets with rising prices is more costly than making a mistake than buying something that is about to decline (I.e. two days of 1% declines lose less value than is made by 2 days of 1% gains, so if you as an indexer wait until day 2 to rebalance, the momentum crowd who bought on day 1 is profiting against you).

So maybe donít sweat it if your portfolio isnít tracking an index.


trollwithamustache

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Re: FT article about problems with indexing and efficient markets
« Reply #1 on: January 02, 2020, 08:55:13 AM »
 
Indexing can and does cause price distortions as individual equities are added or subtracted from indexes.... that doesn't mean VTSAX won't outperform the majority of active fund managers...

MaaS

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Re: FT article about problems with indexing and efficient markets
« Reply #2 on: January 02, 2020, 12:46:16 PM »
I agree with your analysis. There's some truth to the momentum argument, but the impact does feel overstated. My personal view is that some of the concerns about indexing are valid, but we won't get to the scale many fear. There's already evidence coming in from big banks saying many clients are shifting back to active and stock picking with the markets at all-time highs.

Also, it's difficult to prove, but one potential benefit of indexing that these articles rarely mention is a reduction in market volatility. When shares are held in an index fund, they're much less likely to be sold from an earnings miss or a few negative articles.

Of course, the above could hypothetically enhance the sell off in a time of panic. Baby out with the bathwater.

MustacheAndaHalf

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Re: FT article about problems with indexing and efficient markets
« Reply #3 on: January 02, 2020, 02:09:45 PM »
Since there's a paywall, I only read your description of the article.  Wait, does that mean you're paying $360/year for access to FT's website?  That's equal to the expense ratio of over a million dollars invested in Vanguard Total Stock Market ETF (VTI, 0.03% expense ratio)

I don't follow why index funds would "jump in" when prices changed.  They already have a proportional investment.  When price rises, the market cap weighted index raises it's weight in direct proportion.  No change needed.

Historical performance does put pressure on active managers - and it should.  The longer the time frame, the more active managers lose against index funds.  The result is closet indexing, where an "active" fund is highly correlated with an index.  Hedge funds don't seem to do this as much, but that leads to years like 2019 which were truly horrible for them.

Regarding momentum, it's one factor of many.  Some investors also invest in small cap (vs large) or value (vs growth).  Right now value investors are watching massive gains in FAANG stocks, leading to growth beating value.  Momentum is just another factor - sometimes it's profitable, sometimes it's not.

ChpBstrd

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Re: FT article about problems with indexing and efficient markets
« Reply #4 on: January 02, 2020, 08:20:28 PM »
Since there's a paywall, I only read your description of the article.  Wait, does that mean you're paying $360/year for access to FT's website?  That's equal to the expense ratio of over a million dollars invested in Vanguard Total Stock Market ETF (VTI, 0.03% expense ratio)

Ha! No, I freeload with a trial account where I get a handful of free articles a month. It's great information diversification - a chance to see markets from a European perspective, which is often different than the US narratives.

Quote
I don't follow why index funds would "jump in" when prices changed.  They already have a proportional investment.  When price rises, the market cap weighted index raises it's weight in direct proportion.  No change needed.

The article interchanges the concepts of price and market cap because market cap changes daily with share price (ignoring changes in the number of shares for now). If AAPL goes from 4.4% of the S&P 500 to 4.5% of the S&P 500, VTSAX and all the other index funds have to buy more AAPL and sell all the other stocks until their individual stock holdings are again exactly proportional to the S&P 500. Then the S&P 500 changes again, and your fund must trade some more to get back in alignment. Hence the turnover ratio of index funds.

In the author's theory, the index funds are buying AAPL from the momentum traders who picked it up when it went from 4.4% to 4.42% of the S&P 500.

https://www.slickcharts.com/sp500

MustacheAndaHalf

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Re: FT article about problems with indexing and efficient markets
« Reply #5 on: January 03, 2020, 11:31:01 AM »
Free sample articles sounds like a nice way to expand your view of markets.  :)

I don't follow why index funds would "jump in" when prices changed.  They already have a proportional investment.  When price rises, the market cap weighted index raises it's weight in direct proportion.  No change needed.
The article interchanges the concepts of price and market cap because market cap changes daily with share price (ignoring changes in the number of shares for now). If AAPL goes from 4.4% of the S&P 500 to 4.5% of the S&P 500, VTSAX and all the other index funds have to buy more AAPL and sell all the other stocks until their individual stock holdings are again exactly proportional to the S&P 500. Then the S&P 500 changes again, and your fund must trade some more to get back in alignment. Hence the turnover ratio of index funds.

In the author's theory, the index funds are buying AAPL from the momentum traders who picked it up when it went from 4.4% to 4.42% of the S&P 500.
https://www.slickcharts.com/sp500
[/quote]
I think the author is misleading people.  If you look at Vanguard S&P 500 ETF ("VOO"), the turnover rate is 3.7%.  Yet last year the tech sector gained +48% (VGT), raw materials +24% (VAW) and energy +9% (VDE).  If Vanguard has to constantly buy and sell to rebalance differently performing stocks, how could they have 3.7% turnover last year?

It's a rhetorical question, aimed at what the FT author got wrong.  Take another example of two S&P 500 stocks.  Right now, Vanguard S&P 500 ETF holds $22.6 billion in Apple stock, and $14.9 billion in Amazon stock.  If Amazon stock suddenly shoots up by +50%... Vanguard does nothing.  The price goes up +50%, meaning everyone who holds that stock just gained +50%.  So Vanguard's S&P 500 fund has it's Amazon holdings go up +50%, right as that stock should have +50% more weight in the index.  It's an exact match, so Vanguard does nothing.  That's why Vanguard S&P 500 ETF has a turnover of just 3.7%.

For newer MMM members, when you see "market capitalization", that's just stock price times the number of shares.  Most index funds use "market cap" to weight their holdings, so it's really important for that FT author to get it right when discussing index funds.