Index Funds ARE BAD? New Yorker Article

[heybro]

Is Passive Investment Actively Hurting the Economy?
http://www.newyorker.com/business/currency/is-passive-investment-actively-hurting-the-economy

If you have so much as tiptoed into the arena of personal finance over the past few decades, you will have heard about the virtues of passive investing. The argument goes like this: the stock market will outperform other investments over the long term, yet no individual is in a position to outsmart the market as a whole. So the best way to reap the rewards of investing in stocks with minimal risk is to put your money in a fund that tracks the performance of some broad, indexed measure of the market, such as the S. & P. 500. If you have an I.R.A. or a 401(k), there is a reasonably good chance that some of your money is invested this way; low management fees make index funds an attractive option.

[MOD EDIT: Don't post entire articles.  A relevant paragraph or two is fine.]

[GrowingTheGreen]

Interesting thought, but I find it a little ironic that the author keeps quoting Goldman Sachs. Like they don't have a horse in the race or anything...

[P0IS0N]

You know what they say: "Past performance is no guarantee of future results."

[GueroKC]

Other than the Goldman Sachs conflict of interest bit, I thought it was a pretty fair article. There's really no question that Index Funds are the best option for the individual seeing FIRE.

The problem is, markets are supposed to reward winners and thereby encourage growth, but Index Funds by definition don't do this. The big companies are going to have highly valued stock just because they're big companies.

When only a small percentage of the market operates that way, the distortion might be minimal, but Index Funds are so new, that we really have no clue how the market will act if 80% of the market is owned by Index Funds.

(Side note: There are many, MANY other Wall Street funds and practices that distort the market, and Index Funds happen to be one that helps the little guy invest without being killed by fees. So Goldman Sachs can go f*** off with their faux outrage)

[CowboyAndIndian]

The problem is, markets are supposed to reward winners and thereby encourage growth, but Index Funds by definition don't do this. The big companies are going to have highly valued stock just because they're big companies.

Indices are re-balanced every so often.  The companies with a higher stock valuation end up with a larger share of the index then those with a smaller valuation.

If companies do badly, they drop out of the index, so hurting poor performers.

[Johnny Aloha]

Index funds aren't perfect (http://www.joshuakennon.com/sp-500s-dirty-little-secret/), but extensive research has shown it's the best option for most people.  There will always be arguments against indexing, and of course you'll have to inform yourself about author motivations.

[GueroKC]

Sure, but that re-balancing is based on the value of the stocks. So in a world where the value of a stock was mostly determined by the Index Funds investing in it, you can see how a feedback loop would develop.

One idea mentioned in the article is changing Index Funds so that they are re-balanced based on some other indicator, so that loop would be broken.

[Heckler]

There's no way Apple is as big as it is because of indexing. How many of you own AAPL on top of your indices?

What sold it for me is when I realized the mutual funds I was buying at the bank were just a makeup of several index funds, plus an increased MER.

[GueroKC]

According to the article, index funds make up only 20% of the market right now, but it's growing. The concern isn't so much about the current state of the market, but the future state. (i.e. APPL value has very little to do with Indexing)

The popularity of index funds is growing quickly, though, and spreading beyond its original target audience. Institutional investors such as universities and pensions are beginning to realize they're getting shafted by their traditional managers.

For the sake of thought experiment, let's say something horrific comes out about Apple tomorrow. Tim Cook is arrested. Catastrophic mis-management means there's no new iPhone in the works. Whatever constitutes the worst case scenario. What would happen to the stock?

Now imagine that 80 percent of all Apple stock is owned by index funds and the same catastrophe occurs. What would happen to the stock then?

[slugline]

I've been wondering about this as well. I look at active investors as the only ones that have a real "voice" in the market. Every time a share of stock is actively bought/sold, that's a statement of the current price versus other investment alternatives. Passive investors are basically "silent partners" in this endeavor; no matter the headlines of the day, their asset allocation does not change. So, if we ever see a situation where the large majority of investors go passive, the remaining active investors gain disproportionate leverage over the price of stocks. Whether this leverage would confer some sort of advantage is fun to think about.

[Retire-Canada]

Now imagine that 80 percent of all Apple stock is owned by index funds and the same catastrophe occurs. What would happen to the stock then?

Stock price is determined by the buying and selling going on that day. If 20% of Apple were not indexed that is plenty of supply to be sold if those investors determined the value of the company was lower than then current price. The indexers would go along for the ride.

Now if the market was 99.9% indexed I could see a problem.

I think this forum is a perfect example of why that scenario is never going to happen. You'd think MMM Forums would be a bastion of indexing, but even here lots of people "got's the magic!" and figure they can beat the lazy indexers. As long as there are enough special unicorns out there stock prices will continue to adjust the way we expect.

[GueroKC]

I think you're right, Retire-Canada, but I imagine the relatively low proportion of active ownership would keep the price from falling as rapidly as it might otherwise. I guess, to put it in physics terms, higher percentage of index ownership might increase the "mass" of the stock price, making it more difficult to move one way or the other.

[Tyson]

I think you're right, Retire-Canada, but I imagine the relatively low proportion of active ownership would keep the price from falling as rapidly as it might otherwise. I guess, to put it in physics terms, higher percentage of index ownership might increase the "mass" of the stock price, making it more difficult to move one way or the other.

You're describing decreased volatility.  Which might be a good thing.  Or not.

[FINate]

Passive investing threatens a large segment of the finance industry. Not just the big firms like Goldman Sachs, but also the press covering the industry (passive investors make for terrible viewers/consumers), financial advisors, all the way down to business school professors with careers dependent on attracting large numbers of students with the promise of future riches in the industry.

Articles similar to this come out periodically and I always take it as an indication that passive investing is a winning strategy, and that the incumbents know this and are worried. I find it particularly entertaining when I read/hear financial advisors bad mouthing target date funds, which more or less do the same thing (w.r.t. actual investing) but at extremely low costs :)   

[nobodyspecial]

The only solution is to make online investing illegal - just like online gambling.
Then if you want to buy an index you can go to the bank or a financial "adviser" and pay 2.7% like any loyal sucker at the roulette wheel

[aschmidt2930]

The article has a point.  Are they right?  Not sure, but to brush it off as nonsense seems a little foolish.

Does that mean we shouldn't be investing in index funds? No, they're still the best way to build wealth for a majority of investors. 

[FINate]

The article has a point.  Are they right?  Not sure, but to brush it off as nonsense seems a little foolish.

Does that mean we shouldn't be investing in index funds? No, they're still the best way to build wealth for a majority of investors.

The damage from active investing and day trading is enormous. Huge amounts of fees and taxes. People get fooled into buying high and selling low. Publicly traded companies are forced into making short term decisions based on pressure from short term investors. Mutual funds do crazy things like "window dressing." These are massive distortions in our markets that would largely go away with passive index investing. So compared to these things I'm not worried about the point this article makes.

[FINate]

Related: http://knowledge.wharton.upenn.edu/article/passive-but-powerful-how-index-funds-exercise-their-clout/

Essentially index funds are passive investors, but active owners. By definition they can't sell stocks that are underperforming so they tend to take a more active role in making sure companies are managed well.

[Rufus.T.Firefly]

According to the article, index funds make up only 20% of the market right now, but it's growing. The concern isn't so much about the current state of the market, but the future state. (i.e. APPL value has very little to do with Indexing)

The popularity of index funds is growing quickly, though, and spreading beyond its original target audience. Institutional investors such as universities and pensions are beginning to realize they're getting shafted by their traditional managers.

For the sake of thought experiment, let's say something horrific comes out about Apple tomorrow. Tim Cook is arrested. Catastrophic mis-management means there's no new iPhone in the works. Whatever constitutes the worst case scenario. What would happen to the stock?

Now imagine that 80 percent of all Apple stock is owned by index funds and the same catastrophe occurs. What would happen to the stock then?

I think this would just correct itself automatically. Goldman Sachs and the other 20% would see a huge profit opportunity and short the stock. If 80% of the market was blinding following the efficient market hypothesis through index funds, this would simply increase the activity of the other 20% to make profit on inefficient valuations. Over time, the news outlets would write stories about how easy it was to make money by finding incorrectly valued stocks. Soon, individual investors would start betting on individual stocks and speculate. More and more people would move back out of index funds and begin day-trading ...

...kind of like how it's always been. Human nature practically guarantees their will be speculation. Whether its Danish tulips or the Dot-Com bubble, modern history is full of examples of this and it's not going anywhere soon. The stock market is just a device for transferring value from the impatient to the patient.

[nobodyspecial]

I thought high frequency trading was supposed to destroy the market?
Now that 80% of the transactions are HFT it must be all over for the stock picking experts anyway   

[GrowingTheGreen]

Passive investing threatens a large segment of the finance industry. Not just the big firms like Goldman Sachs, but also the press covering the industry (passive investors make for terrible viewers/consumers), financial advisors, all the way down to business school professors with careers dependent on attracting large numbers of students with the promise of future riches in the industry.

Articles similar to this come out periodically and I always take it as an indication that passive investing is a winning strategy, and that the incumbents know this and are worried. I find it particularly entertaining when I read/hear financial advisors bad mouthing target date funds, which more or less do the same thing (w.r.t. actual investing) but at extremely low costs :)

This.  Same reason everyone is freaking out that automation is going to replace jobs.

[Tyson]

The stock market is just a device for transferring value from the impatient to the patient.

LOVE this quote!

[MustacheAndaHalf]

I thought high frequency trading was supposed to destroy the market?
Now that 80% of the transactions are HFT it must be all over for the stock picking experts anyway

Wanted to point out this poster is more astute than the author of the article.  20% ownership does not mean 20% of the trading volume.  The market sets prices on trading volume, not percentage of ownership.

Another flaw in the article is the starting point with this quote:
"The authors focussed specifically on the futures and derivatives markets, studying agriculture, energy, and metals businesses, among others."

Distortions in the futures markets do not automatically translate to the overall stock market.  It's a leap the author makes but never justifies.

[Indexer]

Most of what I wanted to say has been said, but I did have a problem with the following.

Another group of scholars is concerned that index funds can also hurt consumers more directly. In a study of banking ownership and competition, which was published in January, two University of Michigan business-school professors and a management consultant demonstrated that banks whose shares are often packaged in index funds tend to offer higher fees and rates for such services as account maintenance and deposit certificates than banks whose stocks are rarely or never included in index funds. The reason, the authors surmise, is that ownership by index funds gives banks an incentive to behave more as if they have a common owner. The reduced sense of competition leads the banks to charge consumers more.

This is the biggest load of crap. Big banks have higher fees and rates because they can. You can easily get 1% at Ally or 6% interest at Mango, but BofA, Wells Fargo, Chase, etc. still have trillions in deposits. Why?  Most people pick a big bank without really paying attention to the details or doing any research. Those banks also have more branches so they couldn't compete 1on1 with Ally or Mango even if they wanted to. It has nothing to do with the fact that BofA and Wells Fargo are in the same index. Neither bothers to try and compete with Ally on deposit rates, but you can bet they are trying to compete with each other.

[soccerluvof4]

Most of what I wanted to say has been said, but I did have a problem with the following.

Another group of scholars is concerned that index funds can also hurt consumers more directly. In a study of banking ownership and competition, which was published in January, two University of Michigan business-school professors and a management consultant demonstrated that banks whose shares are often packaged in index funds tend to offer higher fees and rates for such services as account maintenance and deposit certificates than banks whose stocks are rarely or never included in index funds. The reason, the authors surmise, is that ownership by index funds gives banks an incentive to behave more as if they have a common owner. The reduced sense of competition leads the banks to charge consumers more.

This is the biggest load of crap. Big banks have higher fees and rates because they can. You can easily get 1% at Ally or 6% interest at Mango, but BofA, Wells Fargo, Chase, etc. still have trillions in deposits. Why?  Most people pick a big bank without really paying attention to the details or doing any research. Those banks also have more branches so they couldn't compete 1on1 with Ally or Mango even if they wanted to. It has nothing to do with the fact that BofA and Wells Fargo are in the same index. Neither bothers to try and compete with Ally on deposit rates, but you can bet they are trying to compete with each other.

Not to raid the thread but if you could share more about this 6% mango thing I would love to hear about it.

[Vilgan]

Not to raid the thread but if you could share more about this 6% mango thing I would love to hear about it.

Having trouble finding the exact offer he's referring to, but there's a lot of savings accounts that advertise a 5% or higher interest rate with there being a lot of small print/effort attached to actually get that rate. Usually a minimum X per month withdrawals, direct deposit, and its only applicable on the first X dollars in the account. If you work hard to tick all the boxes you can get that rate, but considering the actual return involved its not worth the effort for most people. CC churning is probably way more lucrative for your time.

[Indexer]

Not to raid the thread but if you could share more about this 6% mango thing I would love to hear about it.

https://www.mangomoney.com/

http://www.doctorofcredit.com/guide-to-5-interest-prepaidsavings-accounts/

Mango pays 6% on up to 5k, but has a lot of hoops to jump through including $500/month direct deposit. The second link lists other banks paying 5%.  The search function on this site clearly doesn't work well because I've seen several topics about savings accounts paying 5%.

[bb11]

Commenting to follow. Super interesting.

My thoughts after reading the article: This is potentially a concern, but only if indexing becomes much more prevalent than it is now. 50% of the volume or more. Perhaps that will happen some day though. Worthy of open-minded consideration.

[Telecaster]

Sure, but that re-balancing is based on the value of the stocks. So in a world where the value of a stock was mostly determined by the Index Funds investing in it, you can see how a feedback loop would develop.

One idea mentioned in the article is changing Index Funds so that they are re-balanced based on some other indicator, so that loop would be broken.

They mentioned P/E I believe.  Anyway, they mentioned the problem was being weighted by market cap.  For example, AAPL is almost 4% of the S&P 500 by cap, so you can see that if you buy a cap weighted index, you wind up investing more heavily in a few really big companies.   

But if you want to avoid that, there are index ETFs that are equal weighted, for example, RSP is an equal weight S&P 500 index.   They also have a Russell 2000 equal weight, and some sector specifics as well.   

http://performance.morningstar.com/funds/etf/total-returns.action?t=RSP&region=USA&culture=en_US

[Jack]

The day such a high percentage of investors are indexing that the efficient market hypothesis breaks down is the day the world runs out of idiots who think they can do better with active trading. It'll never happen.

[soccerluvof4]

Not to raid the thread but if you could share more about this 6% mango thing I would love to hear about it.

https://www.mangomoney.com/

http://www.doctorofcredit.com/guide-to-5-interest-prepaidsavings-accounts/

Mango pays 6% on up to 5k, but has a lot of hoops to jump through including $500/month direct deposit. The second link lists other banks paying 5%.  The search function on this site clearly doesn't work well because I've seen several topics about savings accounts paying 5%.

Got it ! Thanks!