Jack Bogle warning on index funds

[Daisy]

In trying to convince my father to move to Vanguard index funds, he came across an op-ed written by Jack Bogle recently on the dangers of index funds saturating the market.

This is a question I had for @grantmeaname at CM*TO. Do we run the risk of losing price discovery if EVERYONE invests in index funds?

As an individual investor, I don't know how to mitigate this risk. If everyone does indeed move to index funds (extreme case), then stock prices may get mispriced anyways, so I don't see how active investing will mitigate this risk either.

What do you all think of this issue for the long term?

http://time.com/money/5468239/jack-bogle-index-funds-problem/
http://www2.philly.com/philly/business/john-bogle-vanguard-wsj-index-funds-blackrock-state-street-fidelity-20181129.html

[Radagast]

It seems his argument was about corporate oversight and governance, not price discovery. I have to imagine price discovery is as efficient as ever.

[Daisy]

It seems his argument was about corporate oversight and governance, not price discovery. I have to imagine price discovery is as efficient as ever.

True, maybe I was injecting my own bias into the article. But corporate governance could be an issue. I still do think price discovery will suffer if EVERYONE just automatically buys the index. Who is going to trade stocks individually and determine price?

[ILikeDividends]

Do we run the risk of losing price discovery if EVERYONE invests in index funds?

That is an extremely unlikely hypothetical, in my opinion.  Among other things, you'd need a complete collapse of the mutual fund industry, as well as the same for options markets against individual issues, as predicates for such an event.

How likely do you think that is?

Markets are made by counter parties who disagree with each other, have different motivations, or have different approaches to investing.  If literally everyone thought and acted the same way at the same time, markets wouldn't be able to function at all.

It's kind of like asking, would the Republican party still exist if EVERYONE votes Democratic in the next election?  The logical answer is probably, "no," but I don't think there's anywhere near a non-zero risk of that ever happening.

[Daisy]

Do we run the risk of losing price discovery if EVERYONE invests in index funds?

That is an extremely unlikely hypothetical, in my opinion.  Among other things, you'd need a complete collapse of the mutual fund industry, as well as the same for options markets against individual issues, as predicates for such an event.

How likely do you think that is?

Markets are made by counter parties who disagree with each other, have different motivations, or have different approaches to investing.  If literally everyone thought and acted the same way at the same time, markets wouldn't be able to function at all.

It's kind of like asking, would the Republican party still exist if EVERYONE votes Democratic in the next election?  The logical answer is probably, "no," but I don't think there's anywhere near a non-zero risk of that ever happening.

Well not likely for EVERYONE to go index, but if sufficient people do, as Jack Bogle is predicting, then how are "markets made by counter parties who disagree with each other" if the majority of people just buy into the index?

[ILikeDividends]

Well not likely for EVERYONE to go index, but if sufficient people do, as Jack Bogle is predicting, then how are "markets made by counter parties who disagree with each other" if the majority of people just buy into the index?

Price discovery of individual issues would be achieved by the minority.

I believe there is merit in Jack Bogle's point, in a theoretical sense; however, we've got to be realistic.  I believe the majority of index investors, of whom I consider myself a member of, are unable or unwilling to research individual issues well enough to make a meaningful contribution to price discovery.

Speaking only for myself, any choices I might make on individual issues would only contribute random noise signals into the price discovery function of the market.

If I truly thought I was any good at pricing individual issues (with historical evidence to back that up), I certainly wouldn't settle for indexed returns.

[Daisy]

Well not likely for EVERYONE to go index, but if sufficient people do, as Jack Bogle is predicting, then how are "markets made by counter parties who disagree with each other" if the majority of people just buy into the index?

Price discovery of individual issues would be achieved by the minority.

That was the argument @grantmeaname gave at CM*TO. I still have an uneasy feeling about it, if more than 50% of assets under management are held by passive index funds.

I believe there is merit in Jack Bogle's point; however, we've got to be realistic.  I believe the majority of index investors, of whom I consider myself among a member of, are unable or unwilling to research individual issues well enough to make a meaningful contribution to price discovery.

Speaking only for myself, any choices I might make on individual issues would only be random noise in the price discovery function of the market.

I agree that indexing as an individual investor is the best thing. I have been there and done that on trying to pick stocks. Boy was I smart during the tech boom of the 90s and then dumb during the crash.

However, does it get to the point where it's too good to be true? What happens if assets are severely mispriced due to blind indexing by a majority? As I said in my original post, I don't know a way around it because as an individual investor I am incapable of determining the proper stock price.

[ILikeDividends]

What happens if assets are severely mispriced due to blind indexing by a majority?

Assets can and have been severely mispriced for a whole host of different reasons.  Why focus on just this one scenario?

Severely mispriced assets typically correct sooner or later as long as the market is still functioning.  Stock pickers who are able to spot such pricing errors don't typically wait for indexers to get onto the other side of the boat before they stake out a position.

GE's inclusion in the Dow Jones index didn't prevent its decline and eventual ejection from the index.

To Bogle's point, did the Dow Jones index prolong the mispricing of GE?  Was it ever mispriced due to being in the index?  Maybe.  I don't really know.  But it's certainly not something I'm concerned about.

[nereo]

However, does it get to the point where it's too good to be true? What happens if assets are severely mispriced due to blind indexing by a majority? As I said in my original post, I don't know a way around it because as an individual investor I am incapable of determining the proper stock price.

I think the reason this will never come to pass is because there will always be a very large industry dedicated to NOT investing in index funds.

Think about it - we've now had decades of evidence showing how 80% of actively managed mutual funds can't beat their target index blah blah blah... and *still* there are actively managed funds and even larger hedge funds.  It's human nature to want to beat the average, and there's never a shortage of very smart yet overconfident people who are convinced they can do it.

The boom-bust cycles only reinforce this.  After every crash people lament their losses and a common refrain is "a smart manager/investor could have seen the flashing red signs and known there was trouble ahead - just moving to cash for a efw months would have saved me a bundle!".  We know its also not true - that humans and the algorithms they write are biased and collectively miss every crash because of 'irrational exuberance' and 'recency bias'.

[PDXTabs]

What nereo said, plus:

• Don't forget all the hedge funds.
• Don't forget all the institutional investors.
• If literally everyone was in index funds, suddenly you could beat the market. Enough people would jump into actively managed funds.

[nihilism122]

And what is Bogle's solution to this alleged problem?  Are we not supposed to invest in index funds anymore?

[grantmeaname]

Well not likely for EVERYONE to go index, but if sufficient people do, as Jack Bogle is predicting, then how are "markets made by counter parties who disagree with each other" if the majority of people just buy into the index?

Price discovery of individual issues would be achieved by the minority.

That was the argument @grantmeaname gave at CM*TO. I still have an uneasy feeling about it, if more than 50% of assets under management are held by passive index funds.

Keep in mind that there is a difference between assets under management and transaction volume. Half of all volume (but only a tiny fraction of AUM) belongs to just one genre of hedge funds, the high frequency trading funds, and much of the remaining half of the volume is all of the other genres of hedge funds. (Also, don't forget that some price discovery is handled by players other than funds - individual investors, insiders such as employees with stock options, corporations buying and selling their own stock, M&A players like other companies in the same industry and private equity houses, and rare non-economic participants like governments.)

Here's how I think about the world: in general, equity long-short hedge funds have strong conviction about a few ideas and invest heavily in those ideas, compared to traditional active mutual funds which have many ideas and little conviction about any of them - active portfolio managers are sometimes derided as "closet indexers". $1000 of actively managed mutual fund is a bit like owning $900 of index fund and $100 of a more concentrated hedge fund (fake numbers, with a real ratio that would vary depending on the fund). Hedge funds are getting cheaper - to below the prices of active mutual funds twenty years ago - while active mutual funds hemorrhage money to index funds.

It smells to me like we are headed to a world where the vast majority of AUM is in index funds, which trade as little as possible and pay little fees as a result, and the vast majority of volume is from a small minority of hedge funds which trade heavily around relatively concentrated portfolios. Maybe in that world the hedge funds are compensated for all the hard work they do in researching investment ideas with a small edge of excess performance, or maybe it looks like today's world and they do no better than index investors despite their trouble.

[Daisy]

See other thread on similar topic.

https://forum.mrmoneymustache.com/welcome-to-the-forum/the-father-of-index-funds-sounds-a-warning-on-index-funds/

[Daisy]

And what is Bogle's solution to this alleged problem?  Are we not supposed to invest in index funds anymore?

Hence the conundrum.

I am sticking with index funds, but worry about mass migration to index funds on the market as a whole.

My father, after just reading the headline, now thinks index funds are bad. I told him I was posting a thread on this and would give him the feedback.

[Daisy]

Thanks @grantmeaname .

[Dr. Pepper]

This article brings up an interesting question. In essence when you buy an index who controls the voting rights to those shares, maybe secondarily who should control it? If I had a hypothetical company with public equity, but no index holders vs a company where all my public holders , outside the officers were index holders how would things be different? I would submit in the case of multiple small holders, none of them can really influence the decisions put up to a vote, because the insiders have control of the proxy machinery of the business. The possibility exists for one large holder to buy out the passive minority holders, and form a block that can influence things, but that is not the norm ( especially with modern takeover provisions). If you have all index holders, that removes the possibility (since the index is only selling when people are redeeming), basically further entrenches management. I could imagine a third scenario where the index decides to monitor corporate decisions, and vote down anything that is bad for shareholders, but the time and effort to do this for every company that is indexed would be enormous and prohibitive. Also if the index decided to start playing in corporate decision-making, doesn't that defeat the passive nature of it?

[Panly]

Funds tend to outsource the liability for their voting decisions to outsiders, like ISS.  These consultants are accountable to nobody - a problem that Bogle appears to understand.

[damyst]

I forget where I read it (probably on this forum in a previous similar thread), but someone pointed out that if absolutely everyone were indexing, then a novice value investor who can read a corporate balance sheet could make an absolute killing.
It's an extreme version of the scenario above whereby a small community of active investors determines market prices for everyone else.

[Daisy]

I forget where I read it (probably on this forum in a previous similar thread), but someone pointed out that if absolutely everyone were indexing, then a novice value investor who can read a corporate balance sheet could make an absolute killing.
It's an extreme version of the scenario above whereby a small community of active investors determines market prices for everyone else.

That is a great way to summarize it!

Let's see if my father can be convinced...

[pecunia]

Soooo, he's worried about corporate governance going awry.

"That might leave a power vacuum, leaving corporate chieftains unaccountable. CEOs who run companies supposed to answer to boards of directors, who are in turn elected by shareholders."

Does it really work that way now?  Why are all these CEOs able to act like pigs at a trough whether the company they are "leading" does well or not?  They seem rather unanswerable to most anyone.

Far from me to contradict a wise man like Mr. Bogle, but what he started was a system of Democratic investment.  The votes of the mutual fund shares should carry a lot of weight with those companies.  It could do something like the money invested by the people of Norway presently does.  It could have the opposite effect of what Mr. Bogle suggests and make corporate governance more responsible.  The mutual funds could wield a financial club over some of these "bad boy" corporate leaders representing the interests of the masses.  Companies may have to do more than just wildly seek profits for the next three months.  The long term approach may be favored which may be good for corporate employees, their communities and the environment.  The boom and bust mentality may be shoved out the door.  Research and development may make a resurgence among American companies.

Every cloud has its silver lining.

[OurTown]

I'm going to take this a step further and speculate that the shares owned by the index funds will be robo-voted by AI.

[grantmeaname]

Aren't judgment and nuance and complex systems with hard to quantify uncertainty the hardest things to entrust to an AI?

[PDXTabs]

Aren't judgment and nuance and complex systems with hard to quantify uncertainty the hardest things to entrust to an AI?

Also, AI works really well when you have a bunch of data to "train" it with. For example, if you need to make it through the 2008 financial crisis again there are dozens of hedge funds with well trained models that can do that. AI, today, isn't good at new problems.

[pecunia]

Robot Voted?  There are trillions of dollars invested.  Surely, they can pay some money for someone to be at the helm ensuring people's interests.

[grantmeaname]

They do today.

[markbike528CBX]

They do today.

Thanks @grantmeaname that article on who advises and controls proxy votes was illuminating and a bit worrysome.

I vote my small (<500 shares) of individual stocks.
As a rule I always vote NO on the executive compensation plan.