The End of Indexing as a Strategy, Private Equity Edition

[dungoofed]

Some comments in the Dual Momentum thread got me thinking about what kind of conditions "taking the market" a la Bogleheads would stop working.

We've already had several times the "what would happen if everyone decided to invest passively using index tracking funds/ETFs?" discussion. I still don't see this a threat to indexing as a strategy.

One threat to passive indexing I see is the rise of private equity investment, followed by a late stage IPO. Specifically the case of (software) companies IPOing at massively overvalued prices, indexers being forced to include these companies in their portfolio at these ridiculous valuations, then the stock price deflating while founders, angel investors and VCs make off like bandits. In fact, I'd possibly go so far as to say that the popularity of indexing (and therefore guaranteeing a captive market for the shares post-IPO) is helping create the perfect environment for this very strategy.

Previously most IPOs were made at levels which wouldn't even register an impact on your holdings, after which the company would have to work hard over several years or even decades to prove to Mr Market that the company was profitable long-term. Compare that with now, where if Uber were to not get hyped up any more and just IPO exactly at its current 42 billion dollar valuation, all indexers would suddenly be holding the same amount of Uber stock as they were Starbucks. Then you'd just have to hope that Uber stock wouldn't "do an Alibaba" and deflate as VCs cash out while indexers are left holding the overpriced ball. Many cases of this happening over a period of time would see a massive redistribution of wealth from docile indexers to private equity.

Would appreciate your opinions. I figure there's a reason the above won't play out, and I'm trying to think of similar examples from 1999 but I can't put my finger on it.

[jj20051]

It's an interesting idea and if it happened for long enough the market as a whole would collapse and a recession would set in. VCs would stop buying into technology companies as they'd no longer be profitable (bubbles are only profitable when you can get your money out).

The only problem with the theory is that in a given index fund it appears that approximately 1.3 - 2.5% of all the stocks owned come from any one category. So even if two or three categories continuously fail it wouldn't hurt the index fund return as a whole very much.

[forummm]

Depending on the index criteria, IPOs aren't eligible for inclusion until 6-12 months or more have passed. That's more than enough time for some smart people to realize that the stocks are overvalued, and to short them. The market doesn't always price things "appropriately" (if you know what I mean), but the incentives are there for people to make a lot of money by driving the price to a level that reflects its underlying value.

https://us.spindices.com/documents/methodologies/methodology-sp-us-indices.pdf?force_download=true

[PathtoFIRE]

I was thinking along the same lines, especially after reading this link on Financial Samurai's blog yesterday. I admit, I went on to the slicedinvesting site to see what they offered, but finally convinced myself I was just being foolish trying to chase hedge fund money.

When I've thought about what could disrupt the buy/hold strategy, one thing that comes to mind is taking advantage of the automatic nature of investing these days. Between large endowments, big blocks of individuals all invested in just a few large mutual funds at Vanguard, Fidelity, etc., pension funds, and other institutional investors, I feel like the opportunity for some force to leverage these relatively passive and very large investors into situations that profit from the nature of these investors is getting easier. And not necessarily at the level of cleaning house and leaving the rest of us holding the bag, I'm thinking more along the lines of subtle movements, and changes that leech away small amounts of return. The idea that late IPOs might deprive the market of some of their "run-up" in value makes sense, but I agree that's likely small. But there are probably more serious and far-reaching ways in which this can affect us.

I'm in medicine, and in the US, the financial side of medicine is a mess, and it's only getting more complicated and more difficult to navigate. And you are already seeing ways in which both sides, the payers and the providers, can game the system to eek out a little win here or there, at the expense of the other side. While I know that the movement towards low cost mutual funds is not quite as dramatic as it seems if you hang around here or Bogleheads mostly, I just can't help but think that the financial system "Wall Street" isn't going to figure out some way(s) to get back those lost revenues. Nothing sinister, but where there is a combination of strong motivation ($$$) plus a relatively opaque and complex arrangement, human ingenuity finds a way.

[sol]

I think the main drawback of the traditional indexing strategy is that it is by definition market cap weighted.  Everyone who owns an S&P500 index holds approximately 3% of their investments in Apple right now, exposing them to thousands of times more concentrated risk than would otherwise be recommendable.  The downfall of indexing is that the benefits of broad diversification are made obsolete when one company is 50% of the marketplace.  It wasn't designed to function in that kind of environment.

Whether or not concentrated risk exposure is a real problem is kind of a matter of semantics.  If you believe that Apple is truly 3% of the entire US economy, then that kind of exposure is totally fine, but that seems pretty ridiculous when you consider the number of employees Apple has (~92k) compared to the size of the US working population (~150,000,000), even if you scale for perceived relative productivity.  I think this example makes it pretty clear that market capitalization has nothing to do with economic productivity, yet it's market cap that indexers use as a proxy for betting on the future of the economy.  Even though it's clearly unrelated to GDP.

I'm not sure there is any actionable information there, though. 

[Financial.Velociraptor]

Sol,

I'm not an indexer but once a year I review my returns on a year and inception to date basis versus SPY as I consider that the default opportunity cost.  If I ever start trailing the index, I'll become an indexer.  That said, I'd index to RSP (S*P equal weighted) as it has historically outperformed even with superior diversification.  Maybe that is an argument for a tilt toward mid/small caps versus mega caps.  I don't have a plan for how I'd do an international index portion.  My options investments are almost always on mega caps that derive a large portion of their revenues overseas.  To me, I already have intl built in.

Anyway, I had a point (lol) and that is, it is possible to "index" in an equal weight way.  The funds exist even though the fees might be a little higher.

[forummm]

Sol,

I'm not an indexer but once a year I review my returns on a year and inception to date basis versus SPY as I consider that the default opportunity cost.  If I ever start trailing the index, I'll become an indexer.  That said, I'd index to RSP (S*P equal weighted) as it has historically outperformed even with superior diversification.  Maybe that is an argument for a tilt toward mid/small caps versus mega caps.  I don't have a plan for how I'd do an international index portion.  My options investments are almost always on mega caps that derive a large portion of their revenues overseas.  To me, I already have intl built in.

Anyway, I had a point (lol) and that is, it is possible to "index" in an equal weight way.  The funds exist even though the fees might be a little higher.

A different perspective:
http://www.forbes.com/sites/rickferri/2013/04/29/no-free-lunch-from-equal-weight-sp-500/

[Indexer]

Depending on the index criteria, IPOs aren't eligible for inclusion until 6-12 months or more have passed. That's more than enough time for some smart people to realize that the stocks are overvalued, and to short them. The market doesn't always price things "appropriately" (if you know what I mean), but the incentives are there for people to make a lot of money by driving the price to a level that reflects its underlying value.

https://us.spindices.com/documents/methodologies/methodology-sp-us-indices.pdf?force_download=true

This!  +1

Lets just use Facebook as the example. 
IPO date:  March 18, 2012.
Added to SP 500 index: Dec 11, 2013.

Or Google.
IPO date:  August 2004.
Added to 500 index:  March 2006

So if a company managed to pull this off it might be 18 months before it is added to the index, and potentially longer before it is added to the index funds.  That is a really long time for the company in question to keep their price artificially inflated.

[dungoofed]

Thanks guys. Stay tuned and I'll be back when I have another topic for my series,

The End of Indexing as a Strategy </deepbellowingvoice>

[beltim]

I think the main drawback of the traditional indexing strategy is that it is by definition market cap weighted.  Everyone who owns an S&P500 index holds approximately 3% of their investments in Apple right now, exposing them to thousands of times more concentrated risk than would otherwise be recommendable.  The downfall of indexing is that the benefits of broad diversification are made obsolete when one company is 50% of the marketplace.  It wasn't designed to function in that kind of environment.

Whether or not concentrated risk exposure is a real problem is kind of a matter of semantics.  If you believe that Apple is truly 3% of the entire US economy, then that kind of exposure is totally fine, but that seems pretty ridiculous when you consider the number of employees Apple has (~92k) compared to the size of the US working population (~150,000,000), even if you scale for perceived relative productivity.  I think this example makes it pretty clear that market capitalization has nothing to do with economic productivity, yet it's market cap that indexers use as a proxy for betting on the future of the economy.  Even though it's clearly unrelated to GDP.

I'm not sure there is any actionable information there, though.

Why should number of employees be the relevant measure, especially for a company that outsources almost all of its manufacturing?

Apple actually has a larger than 3% share of US corporate profits. 

[clifp]

Depending on the index criteria, IPOs aren't eligible for inclusion until 6-12 months or more have passed. That's more than enough time for some smart people to realize that the stocks are overvalued, and to short them. The market doesn't always price things "appropriately" (if you know what I mean), but the incentives are there for people to make a lot of money by driving the price to a level that reflects its underlying value.

https://us.spindices.com/documents/methodologies/methodology-sp-us-indices.pdf?force_download=true

This!  +1

Lets just use Facebook as the example. 
IPO date:  March 18, 2012.
Added to SP 500 index: Dec 11, 2013.

Or Google.
IPO date:  August 2004.
Added to 500 index:  March 2006

So if a company managed to pull this off it might be 18 months before it is added to the index, and potentially longer before it is added to the index funds.  That is a really long time for the company in question to keep their price artificially inflated.

However something like VTI tracks this index.

This ETF tracks the CRSP U.S. Total Market Index, which holds almost every liquid U.S. stock. It includes all stocks with a primary listing on a major U.S. stock exchange, incorporated or with a major business presence in the U.S., with a market cap of at least $10 million, with at least 10% of shares publicly available, and that meet minimum trading requirements.

Which means that Google, Facebook were included much earlier along with Zynga and others that didn't fare nearly as well.

[sol]

Apple actually has a larger than 3% share of US corporate profits.

Of you believe that corporate profits are a good proxy for an economy's productivity, then market cap weighed indices make some kind of sense.

I'm not sure many folks believe that, though.

[brooklynguy]

Of you believe that corporate profits are a good proxy for an economy's productivity, then market cap weighed indices make some kind of sense.

But indexers aren't really betting on an expansion in the economy's productivity and using corporate profits as a proxy -- I think it's more accurate to say they are betting on an expansion in corporate profits, which is tied to the economy's productivity.  Like you said, though, it's really just a matter of semantics (and I think we're each now standing on the opposite side of the stance we took in the recent semantical debate about the efficient market hypothesis).

[dungoofed]

Had another think about this, the "late stage" part of "late stage IPO" means VTI would miss out on a lot of the gains that it would have otherwise enjoyed from small-cap growth.

[innerscorecard]

Apple actually has a larger than 3% share of US corporate profits.

Of you believe that corporate profits are a good proxy for an economy's productivity, then market cap weighed indices make some kind of sense.

I'm not sure many folks believe that, though.

Market cap weighted indexes aren't weighted on profits. They are weighted on price. What you said is a non-sequitur.

[sol]

Market cap weighted indexes aren't weighted on profits. They are weighted on price. What you said is a non-sequitur.

Yea, I figured someone would be confused by that.

Think it through though.  We allocate capital to companies based on expectations of profits.  It's a loose connection, I admit, but roughly speaking capital tends to flow towards the expectation of future returns, driving up the price.  At least that's how it's supposed to work.

But indexers aren't really betting on an expansion in the economy's productivity and using corporate profits as a proxy -- I think it's more accurate to say they are betting on an expansion in corporate profits, which is tied to the economy's productivity.

If you ask miles, this depends on what story you believe.  I'm an indexer who believes the index is supposed to reflect the health of the economy, and I expect that the price of the index will rise as the economy expands.  I see corporate profits as a reflection of economic productivity, but certainly not the definition of economic productivity.

[okonumiyaki]

Market cap weighted indexes aren't weighted on profits. They are weighted on price. What you said is a non-sequitur.

Yea, I figured someone would be confused by that.

Think it through though.  We allocate capital to companies based on expectations of profits.  It's a loose connection, I admit, but roughly speaking capital tends to flow towards the expectation of future returns, driving up the price.  At least that's how it's supposed to work.

But indexers aren't really betting on an expansion in the economy's productivity and using corporate profits as a proxy -- I think it's more accurate to say they are betting on an expansion in corporate profits, which is tied to the economy's productivity.

If you ask miles, this depends on what story you believe.  I'm an indexer who believes the index is supposed to reflect the health of the economy, and I expect that the price of the index will rise as the economy expands.  I see corporate profits as a reflection of economic productivity, but certainly not the definition of economic productivity.

Actually, evidence from UK and US stock markets shows that time of high economic growth are not good for shareprices.  High economic growth tends to be periods of high competition and new entrants, and often capital misallocation.  Shares do best when economies are more stable, and companies become oligarchic profit machines. 

[sol]

Actually, evidence from UK and US stock markets shows that time of high economic growth are not good for shareprices.  High economic growth tends to be periods of high competition and new entrants, and often capital misallocation.  Shares do best when economies are more stable, and companies become oligarchic profit machines.

That story makes more sense to me if you succumb to survivorship bias and only track the winners.  Of course the price of lasting companies goes up when they consolidate market share.  But what about total market cap of all companies?  If you think that times of market competition lead to capital misallocation, do you think maybe it's because there is also more capital flooding the markets at those times?  I suspect that total invested dollars rises during periods with high competition and new entrants, even if most of those companies eventually go bust as the winners' stock prices soar.

[skyrefuge]

However something like VTI tracks this index.

This ETF tracks the CRSP U.S. Total Market Index, which holds almost every liquid U.S. stock. It includes all stocks with a primary listing on a major U.S. stock exchange, incorporated or with a major business presence in the U.S., with a market cap of at least $10 million, with at least 10% of shares publicly available, and that meet minimum trading requirements.

Which means that Google, Facebook were included much earlier along with Zynga and others that didn't fare nearly as well.

For the record, CRSP apparently adds IPOs "after trading regular-way for five days on a CRSP exchange of interest."

So, not instantly, but certainly much faster than the S&P indices.

Still, is there actual evidence showing that post-IPO companies are systematically more subject to "over-valuation" than any other companies are?

[brooklynguy]

Resurrecting this old thread to link to this relevant article from yesterday's Wall Street Journal:  "America's Roster of Public Companies Is Shrinking Before Our Eyes".

Besides this thread, there have been other discussions in the forum concerning the rise of private equity and its potential to adversely impact equity investors who invest exclusively in the public stock markets (this thread contained a good one).

The linked WSJ article's main point is as follows:

The U.S. is becoming "de-equitized," putting some of the best investing prospects out of the reach of ordinary Americans. The stock market once offered a way for average investors to buy into the fastest-growing companies, helping spread the nation's wealth. Since the financial crisis, the equity market has become bifurcated, with a private option available to select investors and a public one that is more of a last resort for companies.

And it provides some sobering statistics:

The number of U.S.-listed companies has declined by more than 3,000 since peaking at 9,113 in 1997, according to the University of Chicago's Center for Research in Security Prices. As of June, there were 5,734 such public companies, little more than in 1982, when the economy was less than half its current size.

In the technology industry, the private fundraising market now dwarfs its public counterpart. There were just 26 U.S.-listed technology IPOs last year, raising $4.3 billion, according to Dealogic. Meanwhile, private U.S. tech companies tapped the late-stage funding market 809 times last year, raising $19 billion, Dow Jones VentureSource's data show.

Many of us like to think that our "total stock market" index fund vehicles give us proportionate ownership of every business in the geographic market covered by the applicable index, but we tend to forget that that ownership is necessarily limited to those companies that are publicly traded.  As the WSJ article makes clear, the share of businesses (and, arguably, the share of desirable businesses) that sit outside our reach (in our capacity as index investors) is dramatically expanding.

[maizefolk]

That is a startling decline in number of publicly traded companies.

I do wonder how much of that is a result of the shift of more companies into the private equity and how much (if any) is the result of consolidation with bigger companies buying up smaller ones, or companies that used to do the same thing in different regions of the country merging into single national organizations.

(Also a lot of fun to read through the resurrected thread, which I missed the first time around.)

[NoStacheOhio]

This begs the question, does it make sense to overweight publicly-traded private equity firms, similar to the way some people overweight REITs?

[Grog]

this paper recently caught my attention:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2798653

It is about the Big Three (BlackRock Vanguard StateStreet) and the influence they have on the companies, since they are the largest shareholder of 438 of 500 companies of the S&P500.

" Through an analysis of proxy vote records we find that the Big Three do utilize coordinated voting strategies and hence follow a centralized corporate governance strategy. However, they generally vote with management, except at director (re-)elections. Moreover, the Big Three may exert ‘hidden power’ through two channels: First, via private engagements with the management of portfolio companies; and second, because company executives could be prone to internalizing the objectives of the Big Three. We discuss how this development entails new forms of financial risk."

[steveo]

I don't see anything at all stopping indexing from being the best option for the average person. I accept that indexing mightn't be perfect but there needs to be a better alternative. I can't think of a better alternative.

[Monkey Uncle]

Resurrecting this old thread to link to this relevant article from yesterday's Wall Street Journal:  "America's Roster of Public Companies Is Shrinking Before Our Eyes".

Besides this thread, there have been other discussions in the forum concerning the rise of private equity and its potential to adversely impact equity investors who invest exclusively in the public stock markets (this thread contained a good one).

The linked WSJ article's main point is as follows:

The U.S. is becoming "de-equitized," putting some of the best investing prospects out of the reach of ordinary Americans. The stock market once offered a way for average investors to buy into the fastest-growing companies, helping spread the nation's wealth. Since the financial crisis, the equity market has become bifurcated, with a private option available to select investors and a public one that is more of a last resort for companies.

And it provides some sobering statistics:

The number of U.S.-listed companies has declined by more than 3,000 since peaking at 9,113 in 1997, according to the University of Chicago's Center for Research in Security Prices. As of June, there were 5,734 such public companies, little more than in 1982, when the economy was less than half its current size.

In the technology industry, the private fundraising market now dwarfs its public counterpart. There were just 26 U.S.-listed technology IPOs last year, raising $4.3 billion, according to Dealogic. Meanwhile, private U.S. tech companies tapped the late-stage funding market 809 times last year, raising $19 billion, Dow Jones VentureSource's data show.

Many of us like to think that our "total stock market" index fund vehicles give us proportionate ownership of every business in the geographic market covered by the applicable index, but we tend to forget that that ownership is necessarily limited to those companies that are publicly traded.  As the WSJ article makes clear, the share of businesses (and, arguably, the share of desirable businesses) that sit outside our reach (in our capacity as index investors) is dramatically expanding.

Sounds like the concept of a diversified portfolio needs to be expanded to include an allocation to private equity.  I've never been a proponent of dumping everything into one broad index, because those cap-weighted indices are a lot less diversified than people think.  So maybe a % to private equity, along with US large caps, US small caps, international stocks, and corporate/muni bonds.

[arebelspy]

This begs the question, does it make sense to overweight publicly-traded private equity firms, similar to the way some people overweight REITs?

Is there an index fund of private equity funds?  ;)

[NoStacheOhio]

This begs the question, does it make sense to overweight publicly-traded private equity firms, similar to the way some people overweight REITs?

Is there an index fund of private equity funds?  ;)

As a matter of fact, there are.

PEX and IPRV (can't seem to get it to come up in Fidelity though)

Also: http://www.marketwatch.com/story/private-equity-etfs-arent-fit-for-the-public-2013-05-06

[Proud Foot]

This begs the question, does it make sense to overweight publicly-traded private equity firms, similar to the way some people overweight REITs?

Is there an index fund of private equity funds?  ;)

As a matter of fact, there are.

PEX and IPRV (can't seem to get it to come up in Fidelity though)

Also: http://www.marketwatch.com/story/private-equity-etfs-arent-fit-for-the-public-2013-05-06

Holy Shit!! Talk about expenses. 
PSP - 2.22%
PEX - 0.72%
BIZD - 9.2%

PEX isn't too bad for what it is but the other two are ridiculous.

[NoStacheOhio]

This begs the question, does it make sense to overweight publicly-traded private equity firms, similar to the way some people overweight REITs?

Is there an index fund of private equity funds?  ;)

As a matter of fact, there are.

PEX and IPRV (can't seem to get it to come up in Fidelity though)

Also: http://www.marketwatch.com/story/private-equity-etfs-arent-fit-for-the-public-2013-05-06

Holy Shit!! Talk about expenses. 
PSP - 2.22%
PEX - 0.72%
BIZD - 9.2%

PEX isn't too bad for what it is but the other two are ridiculous.

I never said they were good funds.