Author Topic: Thoughts on indexing  (Read 5421 times)

vand

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Thoughts on indexing
« on: January 09, 2020, 04:58:46 AM »
I am not "anti-indexing", but I think that most investors have not realised the impact that indexing has had on the world of equity investing, how it has fundamentally changed the nature of investing, and the implications of this going forward.

The universal law of investing is that in order to make excess return you must take risk. The risk is that whatever you buy today could fall in price and you are holding an (unrealised) loss. Its generally accepted that equities provide the highest return over time because companies are the wealth-creating engine of a market-based economy. Over time this has borne out to be true; stocks have outperformed every other asset class over the 200-years or so since the industrial revolution.

However, prior to 1974 there was no such thing as an index fund. Buying equities meant you bought shares in companies directly. That meant your investment could go to zero if the company failed (and they often did, of course). This is the very real risk that active stock pickers today still bear.

Indexers rightly point out that while individual companies can go bust, the stock market itself will never fall to zero. This risk has been removed. They also rightly point out that indexing allows you beat the majority of active funds over longer holding periods. Better returns.

So Indexing gives you less risk, better returns.. what's not to like?

Except this now violates the first axiom of investing; that better return generally requires one to take on more risk.

The problem now is that if indexing has made equity investing safer, more predictable, cheaper, and more accessible for everyone, then... why should it reward them just as well as it has done for previous generations who bore much more risk? Market theory says that.. well, it shouldn't, and the risk premium of holding stocks, or at least index funds, should be greatly blunted. 

Translated, what I am saying is if equity investing is are less dangerous than in the past, then to compensate for lower risk you should expect lower returns than the asset class has historically delivered. Maybe that is what we are seeing in this cycle as markets adjust to seemingly ever higher valuations over prolonged periods.

ctuser1

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Re: Thoughts on indexing
« Reply #1 on: January 09, 2020, 07:38:22 AM »
What you are saying is another way to saying that the barrier of entry to the market has been made lower.

If so, that is one more factor, in addition to the the very low interest rate (arguably driven by crappy demographics in countries with money).

If your conjecture is correct, that would boost the PE multiples one time, and keep it higher as long as the barrier of entry is not toughened back again and/or the interest rate shoot up.

Even if it *was* to happen, that is a one time, linear impact. The compounding process that increases stock prices, driven primarily by innovation and supported by modest inflation ("modest" is "anything that is not hyperinflation") is a far more powerful factor to consider because it is exponential in nature. As long as that exponential process does not break down, market is a great place to be.

So if you pit linear processes against an exponential one - linear will *always* lose given enough time. It does not matter how much of a head-start you give to the linear process.

This is a mathematical truth - i.e. the highest form of truth possible as long as the fabric of reality holds, and the kind of truth based on which "God programmed the universe".

If it common to confuse the effect of exponential and linear effects. Human brain did not evolve to consider non-linear concepts well (exponential rise and decay, probability, tail of a statistical distribution etc). I find it easier to first think of these things as mathematical formula, before I come to any intuitive conclusion.

Now it *is* possible that the process of human innovation will break down, or perhaps dissociate itself from the stock market represented by the index funds. That would threaten the exponential process itself. It would be far more serious if you have credible worries about that. It could be argued that the super cheap cost of funding permanently lowers the competitiveness of the economy by keeping zombie entities alive. *That* would, in my opinion, a far more serious worry than a linear impact of lowered barrier of entry - because it calls into question the health of the exponential economic engine that keeps the market going.
« Last Edit: January 09, 2020, 07:40:34 AM by ctuser1 »

nereo

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Re: Thoughts on indexing
« Reply #2 on: January 09, 2020, 07:44:13 AM »
Indexing doe **not** give you “better returns, less risk”.  It gives you average returns, with average risk.

The only “magic” is that most active stock pickers lose to ‘average’ because of fees, herd mentality and various cognitive biases (e.g. price anchoring, confirmation bias etc).

Malcat

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Re: Thoughts on indexing
« Reply #3 on: January 09, 2020, 07:54:45 AM »
Indexing doe **not** give you “better returns, less risk”.  It gives you average returns, with average risk.

The only “magic” is that most active stock pickers lose to ‘average’ because of fees, herd mentality and various cognitive biases (e.g. price anchoring, confirmation bias etc).

Yep.

It's not that no one thinks about this, it's that it comes up about ever 3-4 months here, is effectively talked through, and then no one worries about it again until 3-4 months later when another post like this comes up.

Scandium

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Re: Thoughts on indexing
« Reply #4 on: January 09, 2020, 08:42:34 AM »
We have concern-trolling about indexing now? Lol! I can't tell if OP thinks indexing won't get the returns, or will but don't deserve it?

It's also a great sign with any post that starts with:
"I am not "anti-indexing", but..."
« Last Edit: January 09, 2020, 08:48:46 AM by Scandium »

Buffaloski Boris

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Re: Thoughts on indexing
« Reply #5 on: January 09, 2020, 08:46:26 AM »
I don’t see that indexes really reduce overall risk beyond how people used to reduce risk through having a diversified stock portfolio in days past. If you buy say 40 different Large cap stocks, you’ve greatly reduced your risk of individual company failure. Same thing with an index. The overall market risk of 40 large cap stocks versus a large cap index I’d argue is more or less the same.

ChpBstrd

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Re: Thoughts on indexing
« Reply #6 on: January 09, 2020, 09:56:56 AM »
Well, we are now living in times with a 10 year CAPE > 30 and the S&P’s PE ratio at 24.5. Some explanation is in order.

We can now buy stocks and funds instantly with phones we carry in our pockets for zero commission. In the 1970’s, one had to go through a broker and pay maybe $1,000 commission per trade, and if you wanted a mutual fund prepare to hand over maybe 1.5% per year in fees, plus maybe a front end load of $5k or so. I would certainly buy fewer stocks under that cost structure, and my expected returns would have to be astronomical to cover the cost.

This is also why Amazon can charge higher prices.One-click purchasing and “free” shipping have lowered the deadweight losses and made it so much easier than wading through... Sears..., so people have more willingness to pay. Cottage industries have sprouted up to buy things on less convenient platforms like Alibaba and sell them on Amazon for a profit.

Does this reduce risk? Not a bit. Selling investments is similarly easy, and thanks to the internet, panics can spread faster than ever before. Also, low potential returns in bonds and equities carry their own set of risks. People are probably less attached to investments with limited upside potential, such as stock in companies with saturated, low growth markets bought at earnings yields of 3-5%. Why not sell when one believes the bull run is over, if buy and hold is expected to yield you only 4% in the long run? Low return investments can be high risk too, as will be learned by long term bond investors if inflation ever hits 3% again.

So instead of paying the high fees of the 1970s, we are paying the inflated prices of the 2020s. I’m not saying to sell out - these technical changes are probably permanent - but I am suggesting that market prices have something to do with the technical environment. Convenience is part of what we’re paying for. Also, past returns may not reflect future returns, because the price paid for convenience is a nonproductive asset.

RWD

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Re: Thoughts on indexing
« Reply #7 on: January 09, 2020, 10:01:06 AM »
We have concern-trolling about indexing now? Lol!

Fear mongering is pretty much all vand ever does on here. There's a reason I put him on my ignore list ages ago.

MustacheAndaHalf

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Re: Thoughts on indexing
« Reply #8 on: January 09, 2020, 08:51:38 PM »
Lower costs make active investing easier for individuals, too.  The people who want to buy individual stocks can now do so for $0/trade on multiple platforms.  You can make your own active fund for $0.

Also worth noting: "indexing" is not a monolith.  It doesn't mean everyone indexing owns 100% US Total Stock market.  Some people over-emphasize tech companies, dividends, small caps and/or value stocks.  If you think about it, that's active investing - just at a slower pace.

It also turns out most of the market can't beat the market.  It's a bit misleading to call indexing "average" when it beats 80% of active index funds.  It's quite good, because it accepts the market consensus.

vand

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Re: Thoughts on indexing
« Reply #9 on: January 10, 2020, 02:26:59 AM »
Indexing doe **not** give you “better returns, less risk”.  It gives you average returns, with average risk.

The only “magic” is that most active stock pickers lose to ‘average’ because of fees, herd mentality and various cognitive biases (e.g. price anchoring, confirmation bias etc).

Average, in this context means greater than about 87% of funds over 5 years. You tell me if that is "better" or not.

Most active stock pickers can't beat the indexes because all the returns are increasingly concentrated in a small handful of outperforming stocks, much more that other reasons you cite.

People are still coming at this from the point of view of "indexing is the go-to". Indexing wasn't even an option for most of the history of the asset class. The S&P has delivered 7% real growth for 100+ years.. so what? it's imaginary because you couldn't even buy the S&P for most of history. It was just an imaginary proxy. If you wanted equity exposure you had to go and buy an expensive active mutual fund or pick your own stocks and take your chances.
« Last Edit: January 10, 2020, 02:56:55 AM by vand »

vand

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Re: Thoughts on indexing
« Reply #10 on: January 10, 2020, 02:50:19 AM »
I don’t see that indexes really reduce overall risk beyond how people used to reduce risk through having a diversified stock portfolio in days past. If you buy say 40 different Large cap stocks, you’ve greatly reduced your risk of individual company failure. Same thing with an index. The overall market risk of 40 large cap stocks versus a large cap index I’d argue is more or less the same.

sure, you can pretty much get the same effect by increasing your holdings, but the buy/sell commission on each holding is still an issue if you diversify this way, plus frictional costs for cost-averaging and rebalancing become an issue. I don't think there's any argument that index funds are more efficient for the vast majority of private investors if you seek risk reduction via diversification.

Besides, I think 40 individual stocks is a fairly crazy large number for a private investor.. I would guess most private investors with active portfolios hold probably half this number or fewer.  The advantage of an active portfolio is that it can facilicate the very opposite of diversification; concentration in the stocks which you want to hold.


MustacheAndaHalf

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Re: Thoughts on indexing
« Reply #11 on: January 11, 2020, 06:29:57 AM »
People are still coming at this from the point of view of "indexing is the go-to". Indexing wasn't even an option for most of the history of the asset class. The S&P has delivered 7% real growth for 100+ years.. so what? it's imaginary because you couldn't even buy the S&P for most of history. It was just an imaginary proxy. If you wanted equity exposure you had to go and buy an expensive active mutual fund or pick your own stocks and take your chances.
I don't see anyone suggesting "100+ years" before you mentioned it.

Vanguard's first index fund had it's first full year of operation in 1976, which means 44 years of data.  Are you claiming that's not enough to draw conclusions?

marty998

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Re: Thoughts on indexing
« Reply #12 on: January 11, 2020, 12:28:51 PM »
Surprised that no one has mentioned the rest of the Markowitz portfolio theory here yet.

Your garden variety index fund lies on the "efficient frontier", at the point where you get the highest expected return for a given level of risk.


Indexers rightly point out that while individual companies can go bust, the stock market itself will never fall to zero. This risk has been removed. They also rightly point out that indexing allows you beat the majority of active funds over longer holding periods. Better returns.

So Indexing gives you less risk, better returns.. what's not to like?

Except this now violates the first axiom of investing; that better return generally requires one to take on more risk.

The problem now is that if indexing has made equity investing safer, more predictable, cheaper, and more accessible for everyone, then... why should it reward them just as well as it has done for previous generations who bore much more risk? Market theory says that.. well, it shouldn't, and the risk premium of holding stocks, or at least index funds, should be greatly blunted. 

Translated, what I am saying is if equity investing is are less dangerous than in the past, then to compensate for lower risk you should expect lower returns than the asset class has historically delivered. Maybe that is what we are seeing in this cycle as markets adjust to seemingly ever higher valuations over prolonged periods.


You can diversify out stock specific risk completely with an index fund. You can only get rid of market systemic risk by hedging the market.

But if you do hedge out market risk, then either your expected return is going to be zero, or you're going to reduce your long term returns by the cost of your hedging strategy.

Buffaloski Boris

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Re: Thoughts on indexing
« Reply #13 on: January 11, 2020, 02:22:26 PM »
I don’t see that indexes really reduce overall risk beyond how people used to reduce risk through having a diversified stock portfolio in days past. If you buy say 40 different Large cap stocks, you’ve greatly reduced your risk of individual company failure. Same thing with an index. The overall market risk of 40 large cap stocks versus a large cap index I’d argue is more or less the same.

sure, you can pretty much get the same effect by increasing your holdings, but the buy/sell commission on each holding is still an issue if you diversify this way, plus frictional costs for cost-averaging and rebalancing become an issue. I don't think there's any argument that index funds are more efficient for the vast majority of private investors if you seek risk reduction via diversification.

Besides, I think 40 individual stocks is a fairly crazy large number for a private investor.. I would guess most private investors with active portfolios hold probably half this number or fewer.  The advantage of an active portfolio is that it can facilicate the very opposite of diversification; concentration in the stocks which you want to hold.

Here in the US, the cost for trades at the major discount brokerages has gone to zero. One of the largest, Charles Schwab, has indicated that they’re going to allow purchase and sale of fractional shares as well. Said another way, direct indexing is about to become a thing. I fully intend to take advantage and craft my own “index.”

The devil is always in the details so we’ll see how that actually works out.

cloud72

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Re: Thoughts on indexing
« Reply #14 on: January 12, 2020, 09:16:31 AM »
if stock market is a class room and individual company is a student, Index is just an approximated average score of the whole class room. If a good investor is able to pick out the top 10% of the class, this investor can out perform the class average substantially. 

cloud72

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Re: Thoughts on indexing
« Reply #15 on: January 12, 2020, 09:21:19 AM »
I don’t see that indexes really reduce overall risk beyond how people used to reduce risk through having a diversified stock portfolio in days past. If you buy say 40 different Large cap stocks, you’ve greatly reduced your risk of individual company failure. Same thing with an index. The overall market risk of 40 large cap stocks versus a large cap index I’d argue is more or less the same.

sure, you can pretty much get the same effect by increasing your holdings, but the buy/sell commission on each holding is still an issue if you diversify this way, plus frictional costs for cost-averaging and rebalancing become an issue. I don't think there's any argument that index funds are more efficient for the vast majority of private investors if you seek risk reduction via diversification.

Besides, I think 40 individual stocks is a fairly crazy large number for a private investor.. I would guess most private investors with active portfolios hold probably half this number or fewer.  The advantage of an active portfolio is that it can facilicate the very opposite of diversification; concentration in the stocks which you want to hold.

Here in the US, the cost for trades at the major discount brokerages has gone to zero. One of the largest, Charles Schwab, has indicated that they’re going to allow purchase and sale of fractional shares as well. Said another way, direct indexing is about to become a thing. I fully intend to take advantage and craft my own “index.”

The devil is always in the details so we’ll see how that actually works out.

I constructed my own mini growth fund with 150 stocks even I don't have commission-free trading. My fee is 0.4% right now but will go down to 0.15% in a couple of years. The beauty of the DIY growth fund is that the trading fee is a fixed cost and the portfolio keeps on growing. My own fee is 0.4% but the expected return of this min growth fund is 20% per year so the fee is worth it. The 0.4% fee is because of the need to sell some stocks to raise cash annually because the dividend yield of this fund is only 1%.

Case in point:
one of my holding I  will include in my portfolio:
PaySign, Inc. (PAYS)

28 baggers in 5 years, 90% per year return.

A less aggressive one:
Simulations Plus, Inc. (SLP)

5 baggers in 5 years, 39% per year return.





« Last Edit: January 12, 2020, 09:28:50 AM by cloud72 »

Retire-Canada

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Re: Thoughts on indexing
« Reply #16 on: January 12, 2020, 09:51:17 AM »
if stock market is a class room and individual company is a student, Index is just an approximated average score of the whole class room. If a good investor is able to pick out the top 10% of the class consistently year after year for decades, this investor can out perform the class average substantially.

I added the bold text above since I think that clarification is important.

vand

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Re: Thoughts on indexing
« Reply #17 on: January 12, 2020, 11:26:01 AM »
if stock market is a class room and individual company is a student, Index is just an approximated average score of the whole class room. If a good investor is able to pick out the top 10% of the class, this investor can out perform the class average substantially.

Wrong. The index is the sum of all the invidivual IQs. Big difference.

cloud72

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Re: Thoughts on indexing
« Reply #18 on: January 12, 2020, 11:26:45 AM »
if stock market is a class room and individual company is a student, Index is just an approximated average score of the whole class room. If a good investor is able to pick out the top 10% of the class consistently year after year for decades, this investor can out perform the class average substantially.

I added the bold text above since I think that clarification is important.

Even you added the bold text, that is still true.  A majority of index return comes from a small basket of stocks. Index fund easily contains 1000 stocks but most returns are from the top 1% of stocks. It's like in a society 1% of people hold 99% of the wealth. It's the same with the stock market. Most stocks in an index have negative returns, 0% returns to mediocre returns.
« Last Edit: January 12, 2020, 11:38:33 AM by cloud72 »

chevy1956

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Re: Thoughts on indexing
« Reply #19 on: January 12, 2020, 03:53:05 PM »
if stock market is a class room and individual company is a student, Index is just an approximated average score of the whole class room. If a good investor is able to pick out the top 10% of the class consistently year after year for decades, this investor can out perform the class average substantially.

I added the bold text above since I think that clarification is important.

Yep. My opinion is that you are just as likely to underperform the market as overperform the market especially over a longer time period. I think picking stocks puts you into a poor risk-reward position.

Indexing gives you a much more robust approach to determining your WR and chance of financial success when you live off your portfolio.

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Re: Thoughts on indexing
« Reply #20 on: January 13, 2020, 09:12:09 AM »
Indexing doe **not** give you “better returns, less risk”.  It gives you average returns, with average risk.

The only “magic” is that most active stock pickers lose to ‘average’ because of fees, herd mentality and various cognitive biases (e.g. price anchoring, confirmation bias etc).

Average, in this context means greater than about 87% of funds over 5 years. You tell me if that is "better" or not.

Most active stock pickers can't beat the indexes because all the returns are increasingly concentrated in a small handful of outperforming stocks, much more that other reasons you cite.

People are still coming at this from the point of view of "indexing is the go-to". Indexing wasn't even an option for most of the history of the asset class. The S&P has delivered 7% real growth for 100+ years.. so what? it's imaginary because you couldn't even buy the S&P for most of history. It was just an imaginary proxy. If you wanted equity exposure you had to go and buy an expensive active mutual fund or pick your own stocks and take your chances.

Vand, I think you are mixing up mean and median when you say that the index has returns greater than 87% of active funds. The index returns the average return of the market (mostly active funds), this is higher than the median return because the return distribution is skewed and non-normal.

Boofinator

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Re: Thoughts on indexing
« Reply #21 on: January 13, 2020, 09:22:57 AM »
Indexing doe **not** give you “better returns, less risk”.  It gives you average returns, with average risk.

The only “magic” is that most active stock pickers lose to ‘average’ because of fees, herd mentality and various cognitive biases (e.g. price anchoring, confirmation bias etc).

Slight correction: Average returns, less risk. But one must keep in mind there are two flavors of risk to consider: individual company risk (which is greatly reduced through indexing), and market risk (which is not reduced, but perhaps even enhanced because indexing makes the market feel safer than it is). And stock market risk will be rewarded after the next great crash, when hordes of investors flee toward seemingly 'safer' investments, selling at a loss or not buying at a huge discount. And the cycle shall repeateth….

MustacheAndaHalf

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Re: Thoughts on indexing
« Reply #22 on: January 14, 2020, 11:08:48 PM »
Rather than argue over terms, here's data from SPIVA for mid-2019:
https://www.ifa.com/articles/spiva_-year_2019_active_passive_scorecard/

The S&P 1500 beats most domestic funds, and the percentage gets larger over time:

1-YEAR     3-YEAR       5-YEAR        10-YEAR        15-YEAR
70.97%     69.46%      81.66%       87.88%         87.76%

chevy1956

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Re: Thoughts on indexing
« Reply #23 on: January 14, 2020, 11:40:03 PM »
Rather than argue over terms, here's data from SPIVA for mid-2019:
https://www.ifa.com/articles/spiva_-year_2019_active_passive_scorecard/

The S&P 1500 beats most domestic funds, and the percentage gets larger over time:

1-YEAR     3-YEAR       5-YEAR        10-YEAR        15-YEAR
70.97%     69.46%      81.66%       87.88%         87.76%

Those stats basically state that if you aren't indexing you should expect lower (not greater) returns.

vand

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Re: Thoughts on indexing
« Reply #24 on: January 15, 2020, 03:16:21 AM »
People are still coming at this from the point of view of "indexing is the go-to". Indexing wasn't even an option for most of the history of the asset class. The S&P has delivered 7% real growth for 100+ years.. so what? it's imaginary because you couldn't even buy the S&P for most of history. It was just an imaginary proxy. If you wanted equity exposure you had to go and buy an expensive active mutual fund or pick your own stocks and take your chances.
I don't see anyone suggesting "100+ years" before you mentioned it.

Vanguard's first index fund had it's first full year of operation in 1976, which means 44 years of data.  Are you claiming that's not enough to draw conclusions?

This is a good point, and I have often wondered about it.

My thought is that while indexing has been available since 1976, it has taken very long time to gain traction, and has only really reached a relatively significant proportion in the last 10 years. For a long time it was even considered "un-American" and "un-capitalist" to be getting a free lunch off the back of active investing.. and besides, everyone likes to think they can beat the market no matter what the long term stats show.

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Re: Thoughts on indexing
« Reply #25 on: January 15, 2020, 05:42:00 AM »
Indexing doe **not** give you “better returns, less risk”.  It gives you average returns, with average risk.

The only “magic” is that most active stock pickers lose to ‘average’ because of fees, herd mentality and various cognitive biases (e.g. price anchoring, confirmation bias etc).
for
Slight correction: Average returns, less risk. But one must keep in mind there are two flavors of risk to consider: individual company risk (which is greatly reduced through indexing), and market risk (which is not reduced, but perhaps even enhanced because indexing makes the market feel safer than it is). And stock market risk will be rewarded after the next great crash, when hordes of investors flee toward seemingly 'safer' investments, selling at a loss or not buying at a huge discount. And the cycle shall repeateth….

I wonder if it will repeateth. Is this time different? Seems to be a lot more resiliency at least in the US market. I’m not much invested in US equities so it doesn’t affect me so much. I’m curious if the “buy and hold VTSAX forever” perspective is smoothing out the bumps over time in the macro sense.

nereo

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Re: Thoughts on indexing
« Reply #26 on: January 15, 2020, 06:35:17 AM »
Thankfully, there are good data on the size of assets held in index funds.  Most recently (2019) money held in index funds eclipsed those in actively managed portfolios, and both stand at roughly $4.6T.  For an historical context, in 2010 index funds made up ~25% of the market, and in 2000 they were about 12%.

So there is no question that index investing has gone from a rather inconsequential fraction of the total market to a substantial percentage just over the last three decades.

The follow up question is whether having so many assets tied to passive investing somehow ‘distorts’ or influences the market. 

As mentioned up-thread, we’ve had this discussion countless times on this very forum - it seems like every 6 months or so a new thread on this very subject pops up.  While it’s all prognosticating, my take-home from all this debate is that active investing still has so much capital (>$4T) that its responsible for setting the price of all but the smallest small-cap stocks (the so-called “market efficiency theory”).  And there’s a mechanism for this to remain the case - if over time active stock picking became such a small fraction of the total market cap that stocks were no longer priced effectively, it would become relatively simple for even your average hedge-fund manager to beat the market.  Clearly that is not happening yet.  If ever it started happening with regularity, investors would flock back to actively managed funds, and there would be some ‘self correction’.

My money is on index funds never exceeding 80% of total market share.  Hubris will always convince many that they can ‘beat the market’ and fear will always push people towards fund managers who promise to hold their hand through investing and use effective marketing speak like “capital protection” and “broad market-based risk analysis.  While 80% might sound like index funds dominate everything, this would still leave ~$2T in actively traded accounts - more than enough to move the needle of even the largest companies.

MustacheAndaHalf

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Re: Thoughts on indexing
« Reply #27 on: January 15, 2020, 10:09:01 AM »
People are still coming at this from the point of view of "indexing is the go-to". Indexing wasn't even an option for most of the history of the asset class. The S&P has delivered 7% real growth for 100+ years.. so what? it's imaginary because you couldn't even buy the S&P for most of history. It was just an imaginary proxy. If you wanted equity exposure you had to go and buy an expensive active mutual fund or pick your own stocks and take your chances.
I don't see anyone suggesting "100+ years" before you mentioned it.

Vanguard's first index fund had it's first full year of operation in 1976, which means 44 years of data.  Are you claiming that's not enough to draw conclusions?
This is a good point, and I have often wondered about it.

My thought is that while indexing has been available since 1976, it has taken very long time to gain traction, and has only really reached a relatively significant proportion in the last 10 years. For a long time it was even considered "un-American" and "un-capitalist" to be getting a free lunch off the back of active investing.. and besides, everyone likes to think they can beat the market no matter what the long term stats show.
Ah, that clarifies your view a bit.  I think you're saying the impact this level of assets in passive indexing is untested, and that it's unclear what results from a significant fraction of equities being held by passive index funds.

The books I read about high-frequency trading (HFT, like in books "Flash Boys", "Dark Pools") convinced me that the amount of assets don't matter - is how often they move.  Instead of using rough numbers, I'll borrow from the wiki page for HFT (https://en.wikipedia.org/wiki/High-frequency_trading).  HFT firms have insignificant assets, but "on average initiated 10–40% of trading volume in equities" (in 2017).  The article mentions that ~2% of firms are HFT firms.  The firm might trade many times per second, every minute, every hour, every week, all year long.  When you multiply insignificant assets by millions of times per year, it has a significant impact on the market's price discovery.

Couldn't passive index funds loan their assets to HFT firms during the market hours?  As long as a mutual fund is guaranteed to have the assets back by market close, and then earns fees for doing so, everyone would benefit.  I think it might be possible some assets of passive index funds are active in the market during the day - on loan.

vand

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Re: Thoughts on indexing
« Reply #28 on: January 16, 2020, 01:02:51 AM »
People are still coming at this from the point of view of "indexing is the go-to". Indexing wasn't even an option for most of the history of the asset class. The S&P has delivered 7% real growth for 100+ years.. so what? it's imaginary because you couldn't even buy the S&P for most of history. It was just an imaginary proxy. If you wanted equity exposure you had to go and buy an expensive active mutual fund or pick your own stocks and take your chances.
I don't see anyone suggesting "100+ years" before you mentioned it.

Vanguard's first index fund had it's first full year of operation in 1976, which means 44 years of data.  Are you claiming that's not enough to draw conclusions?
This is a good point, and I have often wondered about it.

My thought is that while indexing has been available since 1976, it has taken very long time to gain traction, and has only really reached a relatively significant proportion in the last 10 years. For a long time it was even considered "un-American" and "un-capitalist" to be getting a free lunch off the back of active investing.. and besides, everyone likes to think they can beat the market no matter what the long term stats show.
Ah, that clarifies your view a bit.  I think you're saying the impact this level of assets in passive indexing is untested, and that it's unclear what results from a significant fraction of equities being held by passive index funds.

The books I read about high-frequency trading (HFT, like in books "Flash Boys", "Dark Pools") convinced me that the amount of assets don't matter - is how often they move.  Instead of using rough numbers, I'll borrow from the wiki page for HFT (https://en.wikipedia.org/wiki/High-frequency_trading).  HFT firms have insignificant assets, but "on average initiated 10–40% of trading volume in equities" (in 2017).  The article mentions that ~2% of firms are HFT firms.  The firm might trade many times per second, every minute, every hour, every week, all year long.  When you multiply insignificant assets by millions of times per year, it has a significant impact on the market's price discovery.

Couldn't passive index funds loan their assets to HFT firms during the market hours?  As long as a mutual fund is guaranteed to have the assets back by market close, and then earns fees for doing so, everyone would benefit.  I think it might be possible some assets of passive index funds are active in the market during the day - on loan.

Indeed you make a very good point about the rise of HFT also which is another massive factor that shapes the markets today. I think the the overarching theme is that markets are always evolving. The nature of "the stock market" is completely different to what it was in the past.  The players change from one generation to the next, but everyone still has to coexist in same space. When they all push in the same direction we get what we have seen in the last 10 years, which is an unbelievably benign risk-on environment. When they start tugging in opposite directions things will get interesting.

habanero

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Re: Thoughts on indexing
« Reply #29 on: January 16, 2020, 03:38:24 AM »
Those stats basically state that if you aren't indexing you should expect lower (not greater) returns.

Remeber that most funds that invest in the stockmarket has and has always had a pretty high correlation to a benchmark index. Even when it isn't called indexing its pretty close in a lot of cases. And in this scenario the higher cost of anything actively or "actively" managed are often enough to explain the underperformance. Also when you know that a large part of the index performance comes from relatively few stocks, you don't have to get much wrong before you start underperforming the index.

And if you take the aggregate of the non-indexed mutual fund universe you are probably even closer to the actual index anyway. In which case the higher annual costs kills the performance for the vast majority over time.

k9

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Re: Thoughts on indexing
« Reply #30 on: January 16, 2020, 05:24:12 AM »
The problem now is that if indexing has made equity investing safer, more predictable, cheaper, and more accessible for everyone, then... why should it reward them just as well as it has done for previous generations who bore much more risk? Market theory says that.. well, it shouldn't, and the risk premium of holding stocks, or at least index funds, should be greatly blunted.

The trick is, as more and more people invest in the (say) 500 biggest companies in the US, it just makes them more and more expensive relative to the overall market with no fundamental underlying reason. Meaning, the 501st company is not bought as much as the others. If company #500 is valued at, say 1,01 billion and company #2 is at 1,00, and index investor will buy company #500 just because it is #500 (which is a kind of stock picking, in a way), making it now cost 1,02 billion (yeah, this is a big investor). If you arrive on the market just after that, does it really make sense to buy #500 at 1,02 rather than #501 at 1,00?

You might say "easy, I just buy a whole market index". But they incur bigger costs: let's say there's a fund that tracks 10,000 companies, that means some of these companies ar so small that they are only worth 0,0001% of any index share. If I invest $1,000 in that fund, the fund owner has to buy $0,0001 of shares for that company, which is obviously a bit complicated. That means 2 things : these funds are more expensive, and the fund managers have to "cheat" a little: they don't buy the, say, last 1,000 companies, because it's not cost effective and it has not actual impact on the index. But these companies are not invested in, so you're back to square 1.

habanero

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Re: Thoughts on indexing
« Reply #31 on: January 16, 2020, 06:03:04 AM »
Our national pension fund, which is one of the largest index investors out there (they own 1-2% of "every" listed equity in the (developed) world) has voiced some concerns that they forfeit large gains by actually having to wait until something gets listed before they can buy it. They are playing with the idea of also being able to invest in unlisted equity and thereby capturing a larger share of the upside. They are looking at being late-phase investors, i.e. where an upcoming IPO is highly likely. Over the last 20 years taking or leaving companies private has become more common due to among other highs much higher regulatory costs of being listed. Another new invention is to be able to rise large amounts of capital without getting listed at all. For some companies an IPO isn't about rising capital at all - it's just a vehicle for founders and others early to the party to cash in.

MustacheAndaHalf

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Re: Thoughts on indexing
« Reply #32 on: January 17, 2020, 11:36:48 AM »
It's worth noting that correlation is not performance.  If bonds and stocks both move upwards for a time, they are 100% correlated during that time, even if stocks are dramatically outperforming bonds.  I posted a link earlier with passive index fund performance vs active funds.

Investors long ago figured out buying the #501 stock and waiting for S&P to list it (causing Vanguard/iShares to buy it in bulk).  Vanguard got wise to that, and for many years Vanguard S&P 500 has held ~506 stocks or so.  So the #501 stock shouldn't jump much when it's listed, since Vanguard S&P 500 already holds it (I assume other funds did the same).  But more importantly, if this is your concern, there are larger indexes to buy: S&P 1500 ... Schwab's US Broad Market (~2500) ... Vanguard or iShares Total Stock Market (~3500).
« Last Edit: January 17, 2020, 11:38:19 AM by MustacheAndaHalf »

k9

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Re: Thoughts on indexing
« Reply #33 on: January 19, 2020, 11:56:08 AM »
Investors long ago figured out buying the #501 stock and waiting for S&P to list it (causing Vanguard/iShares to buy it in bulk).  Vanguard got wise to that, and for many years Vanguard S&P 500 has held ~506 stocks or so.  So the #501 stock shouldn't jump much when it's listed, since Vanguard S&P 500 already holds it

Good point.

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Re: Thoughts on indexing
« Reply #34 on: January 19, 2020, 01:03:58 PM »
Investors long ago figured out buying the #501 stock and waiting for S&P to list it (causing Vanguard/iShares to buy it in bulk).  Vanguard got wise to that, and for many years Vanguard S&P 500 has held ~506 stocks or so.  So the #501 stock shouldn't jump much when it's listed, since Vanguard S&P 500 already holds it

Good point.

Perhaps flogging the horse at this point, but worth noting that the 500th company in the SP index is <0.01% due to weight indexing. So it can matter a great deal to the company in question if it is included/excluded in the index, but if changes the index very little and won’t be noticed by shareholders

Same happens when a company is added or dropped from the DOW, only its more dramatic. Investors will load up in a company that seems destined to be include ( or dump shares of the next company expected to be dropped) because of countless 401ks and muni funds that will auto invest. In other words : it’s already priced in.

Villanelle

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Re: Thoughts on indexing
« Reply #35 on: January 19, 2020, 02:51:50 PM »
It's worth noting that correlation is not performance.  If bonds and stocks both move upwards for a time, they are 100% correlated during that time, even if stocks are dramatically outperforming bonds.  I posted a link earlier with passive index fund performance vs active funds.

Investors long ago figured out buying the #501 stock and waiting for S&P to list it (causing Vanguard/iShares to buy it in bulk).  Vanguard got wise to that, and for many years Vanguard S&P 500 has held ~506 stocks or so.  So the #501 stock shouldn't jump much when it's listed, since Vanguard S&P 500 already holds it (I assume other funds did the same).  But more importantly, if this is your concern, there are larger indexes to buy: S&P 1500 ... Schwab's US Broad Market (~2500) ... Vanguard or iShares Total Stock Market (~3500).


Didn't know this.  Learning has occurred.  Thank you. 

Boofinator

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Re: Thoughts on indexing
« Reply #36 on: January 21, 2020, 09:29:36 AM »
Investors long ago figured out buying the #501 stock and waiting for S&P to list it (causing Vanguard/iShares to buy it in bulk).  Vanguard got wise to that, and for many years Vanguard S&P 500 has held ~506 stocks or so.  So the #501 stock shouldn't jump much when it's listed, since Vanguard S&P 500 already holds it

Good point.

Perhaps flogging the horse at this point, but worth noting that the 500th company in the SP index is <0.01% due to weight indexing. So it can matter a great deal to the company in question if it is included/excluded in the index, but if changes the index very little and won’t be noticed by shareholders

Same happens when a company is added or dropped from the DOW, only its more dramatic. Investors will load up in a company that seems destined to be include ( or dump shares of the next company expected to be dropped) because of countless 401ks and muni funds that will auto invest. In other words : it’s already priced in.

Or more specifically, it's probabilistically priced in. To use an example, if investors think there's an 80% chance that a company will be added to the DOW, the price should reflect about 80% of the increase between the price of the unlisted company and investors' estimates of the listed price. So there'll still be a bump when it gets listed, it just won't be anywhere close to the difference between an unlisted company (that isn't expected to be added) and a listed company. (On the flip side, if the company doesn't get listed as expected, there'll be a much bigger drop than the expected gain.)

ChpBstrd

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Re: Thoughts on indexing
« Reply #37 on: January 21, 2020, 12:09:49 PM »
Investors long ago figured out buying the #501 stock and waiting for S&P to list it (causing Vanguard/iShares to buy it in bulk).  Vanguard got wise to that, and for many years Vanguard S&P 500 has held ~506 stocks or so.  So the #501 stock shouldn't jump much when it's listed, since Vanguard S&P 500 already holds it

Good point.

Perhaps flogging the horse at this point, but worth noting that the 500th company in the SP index is <0.01% due to weight indexing. So it can matter a great deal to the company in question if it is included/excluded in the index, but if changes the index very little and won’t be noticed by shareholders

Same happens when a company is added or dropped from the DOW, only its more dramatic. Investors will load up in a company that seems destined to be include ( or dump shares of the next company expected to be dropped) because of countless 401ks and muni funds that will auto invest. In other words : it’s already priced in.

Or more specifically, it's probabilistically priced in. To use an example, if investors think there's an 80% chance that a company will be added to the DOW, the price should reflect about 80% of the increase between the price of the unlisted company and investors' estimates of the listed price. So there'll still be a bump when it gets listed, it just won't be anywhere close to the difference between an unlisted company (that isn't expected to be added) and a listed company. (On the flip side, if the company doesn't get listed as expected, there'll be a much bigger drop than the expected gain.)

Even that would create an easy arbitrage opportunity. If my hedge fund bought several companies on the periphery of the DJIA or S&P 500 at a price reflecting how close they are to being included, then on the day any of those companies gets included in the index, this hypothetical index premium goes from 80%, for example, to 100%. Meanwhile, the odds stay close to the same for my remaining companies. So my hedge fund just earned a premium in addition to the market.

Boofinator

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Re: Thoughts on indexing
« Reply #38 on: January 22, 2020, 09:05:41 AM »
Investors long ago figured out buying the #501 stock and waiting for S&P to list it (causing Vanguard/iShares to buy it in bulk).  Vanguard got wise to that, and for many years Vanguard S&P 500 has held ~506 stocks or so.  So the #501 stock shouldn't jump much when it's listed, since Vanguard S&P 500 already holds it

Good point.

Perhaps flogging the horse at this point, but worth noting that the 500th company in the SP index is <0.01% due to weight indexing. So it can matter a great deal to the company in question if it is included/excluded in the index, but if changes the index very little and won’t be noticed by shareholders

Same happens when a company is added or dropped from the DOW, only its more dramatic. Investors will load up in a company that seems destined to be include ( or dump shares of the next company expected to be dropped) because of countless 401ks and muni funds that will auto invest. In other words : it’s already priced in.

Or more specifically, it's probabilistically priced in. To use an example, if investors think there's an 80% chance that a company will be added to the DOW, the price should reflect about 80% of the increase between the price of the unlisted company and investors' estimates of the listed price. So there'll still be a bump when it gets listed, it just won't be anywhere close to the difference between an unlisted company (that isn't expected to be added) and a listed company. (On the flip side, if the company doesn't get listed as expected, there'll be a much bigger drop than the expected gain.)

Even that would create an easy arbitrage opportunity. If my hedge fund bought several companies on the periphery of the DJIA or S&P 500 at a price reflecting how close they are to being included, then on the day any of those companies gets included in the index, this hypothetical index premium goes from 80%, for example, to 100%. Meanwhile, the odds stay close to the same for my remaining companies. So my hedge fund just earned a premium in addition to the market.

Except that the 20% that don't get listed will revert back to the delisted price, which will be a drop of 80% of the delta between a listed and delisted company, ergo no arbitrage opportunity. So yeah, it's already priced in (at least for ordinary investors like (presumably) us).

vand

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Re: Thoughts on indexing
« Reply #39 on: May 04, 2020, 12:41:40 PM »
Some similar musing from Ben Carlson about future stock market returns:
https://awealthofcommonsense.com/2020/04/my-new-theory-about-future-stock-market-returns/

We know now with hindsight and more than 100 years of good quality data that equities have returned far greater growth than virtually every other asset class on an unleveraged basis. That additional 3-4% or whatever compounds out to a very big number over enough years. 

As markets have evolved and become more mature with more history and more data, any old schmuck can pull up a long term chart of the market and see that simply buying and hold stocks would have made them very wealthy and and decided that they want a piece of the action... then then but this simple act itself raises valuations and reduces the future return holders will enjoy.. The uncomfortable truth is that stock market can't make everyone rich.. if everyone was mustachian and decided to put their money into stocks then valuations would be so high that future returns themselves would be all but zero.

Carlson makes a good point too that, now the Fed effectively backstops every downturn with whatever is necessary then the market is less risky than ever, therefore it follows that expected returns should also be correspondingly lower .

Buffaloski Boris

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Re: Thoughts on indexing
« Reply #40 on: May 04, 2020, 02:40:14 PM »
Mr. Carlson has an interesting theory and he may be right. As the Fed is effectively decreasing risk, the premiums we expect from the US stock market would go down as well. That might be part of why equities outside the US are less expensive as measured by CAPE and PE ratios. They are perceived as being less risky. In my view, even if it’s true it’s unsatisfactory. Because you’re trading economic risk for political risk; I.e the risk that the central bank will continue to backstop.

Thought experiment: if this true, then why the price difference between US and say U.K. or Japan equities? Are not the central banks in all 3 places in essence backstopping markets?

Telecaster

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Re: Thoughts on indexing
« Reply #41 on: May 04, 2020, 04:18:59 PM »
IMO, it isn't really valid to compare P/E ratios between countries, because each country has its own rules/business traditions, expectations for growth, and set of risks.

vand

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Re: Thoughts on indexing
« Reply #42 on: June 10, 2020, 03:41:13 AM »
This is a good article illustrating how gaining equity exposure used to be for the retail investor back in 1972:

https://jasonzweig.com/are-you-a-better-investor/

Index trackers don't exist yet.  If you want to buy a mutual fund it's typically a 8%-10% front end load charge. 7% of trades "failed to deliver".

It's difficult to imagine how investors wouldn't demand a higher expected return on their capital given these associated costs & risks than they do in today's much more benign investing environment.

nereo

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Re: Thoughts on indexing
« Reply #43 on: June 10, 2020, 05:01:45 AM »


It's difficult to imagine how investors wouldn't demand a higher expected return on their capital given these associated costs & risks than they do in today's much more benign investing environment.

Marketing, coupled with a sufficiently wide moat in the industry and a generally poor understanding of finances.  Then (as now) brokerages spent a fortune telling customers that finance was horribly complex and they needed someone to manage their money or they’r wind up on the rocks of destitution. Unlike today, Internet forums such as this one weren’t a thing and an investor couldn’t buy an individual stock without a huge commission ad expensive mutual funds wee the norm.  So it was fairly easy for fund managers to convince the average joe that their fund performance of +2% was ‘GREAT!” Because (insert jumbo-jumbo financial terms like ‘beta-diversity’ and ‘downside risk’).   Without a great alternative average Joe/Jane looked at their $10,000 invested, saw it was now $10,800 a couple years later and said “I’m winning!”

habanero

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Re: Thoughts on indexing
« Reply #44 on: June 10, 2020, 08:02:29 AM »

Thought experiment: if this true, then why the price difference between US and say U.K. or Japan equities? Are not the central banks in all 3 places in essence backstopping markets?


In Japan the central bank has been buying equity ETFs outright since 2010.

https://www.bloomberg.com/news/articles/2020-04-06/when-the-federal-reserve-buys-etfs-thank-the-bank-of-japan

MustacheAndaHalf

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Re: Thoughts on indexing
« Reply #45 on: June 10, 2020, 09:57:17 AM »
Ben Carson's article says there's less risk in markets overall because of the Fed's actions.

I can't quite reconcile that with the 5 largest U.S. companies all taking big drops in March.  Each of them are so dominant they risk anti-trust action, and all have large cash reserves.  On March 8, the Fed dropped rates to 0% and announced 2008-style quantitative easing.  Then it intervened again days later, providing liquidity to the malfunctioning treasury market.  After all of that, there were still severe stock market drops.

Most of the time, the Fed doesn't intervene.  Companies are allowed to go bankrupt without Fed action.  And even when the Fed acts, companies can suffer severe price drops.  I guess I view the Fed as not having as big an impact as Ben Carson believes.

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Re: Thoughts on indexing
« Reply #46 on: June 10, 2020, 10:00:44 AM »
Bogle has talked about the concentration of power to Vanguard, Blackrock, etc. Since they create the index funds they have more power over board makeup etc. With the rise and concentration of indexes we'll probably see the 3 major brokerages control/increase their influence over companies.
« Last Edit: June 10, 2020, 10:24:02 AM by sixwings »