Author Topic: What if nearly everybody used Index Funds?  (Read 5508 times)

Leisured

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What if nearly everybody used Index Funds?
« on: July 09, 2013, 05:20:09 AM »
There is a slight risk to Index Funds. If most people used them, then index funds would buy and sell, to keep their investments in line with the market, but the market would be changing because of the rebalancing by index funds. The market and index funds would echo off each other, and the market would become volatile in a random way.

It is very unlikely that most investors would be in index funds in the future, but I wanted to raise the matter.


marty998

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Re: What if nearly everybody used Index Funds?
« Reply #1 on: July 09, 2013, 06:02:58 AM »
I like these topics. Take "situation normal", run it to the extreme and see what happens.

So lets do that. Lets assume there is one fund in the world, which owns every single commercial enterprise in the world. If you assume the fund needs all the money in the world to buy every enterprise in the world....and once it has bought everything what happens when a little old lady in Cyprus pull her money from under the mattress and decides to invest in this fund that has nothing left to buy.....ok I'm running into a few thought problems here, nothing a shot of whisky can't fix.

Ok lets try something different.

If 100% of money was in index funds there would be no buying and selling (no market?) and no rebalancing because stocks wouldn't go in and out of indexes??? I feel like I'm hitting a limitation of theory vs practical reality. How can you test something like this?

The point I want to try to make is that I think healthy competition is the saviour. Guarantee you a slick haired self-styled hedge fund manager will assess the situation, short it and make a truckload of money out of it.

That fabled invisible hand should guide our funds to the most attractive investment opportunities, be they the man who runs the ice cream van business or the MSCI world index. Speaking as someone who works in funds management, I know there will always be enough investors out there who believe they can find a manager (and pay for a manager) who will generate alpha for them. To paraphrase James Bond..."the index is not enough".

For me, I don't want to track an index in a falling market. I want a manager who will find a way to preserve my capital. If he underperforms in a rising market then so be it. I would prefer slightly lower returns as a trade off for slightly lower volatility.

matchewed

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Re: What if nearly everybody used Index Funds?
« Reply #2 on: July 09, 2013, 06:07:28 AM »
There is a slight risk to Index Funds. If most people used them, then index funds would buy and sell, to keep their investments in line with the market, but the market would be changing because of the rebalancing by index funds. The market and index funds would echo off each other, and the market would become volatile in a random way.

It is very unlikely that most investors would be in index funds in the future, but I wanted to raise the matter.

Your point also misses all the other type of investors who would invest in individual companies other than individual investors. Or the individuals who are already "super" rich and can get preferred stock and are not investing in individual companies like we can.

aclarridge

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Re: What if nearly everybody used Index Funds?
« Reply #3 on: July 09, 2013, 07:03:04 AM »
There is a slight risk to Index Funds. If most people used them, then index funds would buy and sell, to keep their investments in line with the market, but the market would be changing because of the rebalancing by index funds. The market and index funds would echo off each other, and the market would become volatile in a random way.

It is very unlikely that most investors would be in index funds in the future, but I wanted to raise the matter.

Sounds like a reasonable point to me - if there weren't enough other players to make a market, then the prices would certainly become more volatile and would all generally follow the inflows and outflows to the index fund.

Don't think it would ever happen though because if we got anywhere near, there would be such huge business in market making for the index funds that people would invest in that instead. A balance has to be kept there.

arebelspy

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Re: What if nearly everybody used Index Funds?
« Reply #4 on: July 09, 2013, 09:40:54 AM »
This has been discussed "a bazillion times" over on the Bogleheads forum. Head over, do a search and give the threads a read.

Here's the link for you: https://www.google.com/search?hl=en&safe=off&q=if+everybody+indexed+site:bogleheads.org
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grantmeaname

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Re: What if nearly everybody used Index Funds?
« Reply #5 on: July 09, 2013, 11:52:35 AM »
Mutual funds are only a quarter of the market. Hedge funds, pension funds, nonprofit endowments, insurance companies, stock held in corporate treasuries, stock held directly by day traders and stock given to top management as incentive pay are all important too.

kyleaaa

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Re: What if nearly everybody used Index Funds?
« Reply #6 on: July 10, 2013, 08:56:53 PM »
I would like to point out that the markets are already volatile in a random way. If what you are talking about happened, the market would actually become LESS random and MORE predictable than it is now, making active trading extremely profitable. There is a 0% chance most money will ever be invested in index funds, so I wouldn't spend much time thinking about it.
« Last Edit: July 10, 2013, 08:59:19 PM by kyleaaa »

Leisured

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Re: What if nearly everybody used Index Funds?
« Reply #7 on: July 15, 2013, 07:47:20 PM »
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.

arebelspy

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Re: What if nearly everybody used Index Funds?
« Reply #8 on: July 15, 2013, 11:05:23 PM »
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.

No worries.  It's a very common question most people have when they first hear of an idea that's outside the norm or "extreme" versus what they're used to: is it sustainable?

:)
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