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Dangers of indexing?
Old 09-22-2010, 11:53 PM   #1
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Dangers of indexing?

Here's an interesting discussion of potential dangers in index investing.

FT Alphaville Did nobody ever consider that indexing was dangerous?

The original paper is here, but before you can read it you have to be a purchaser, subscriber, journalist, govt employee, or resident of a developing country.

The (summarized) arguments leave a lot of things unanswered IMO, but it's interesting to consider various flaws in the gospel of indexing, which I adhere to closely.
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Old 09-22-2010, 11:57 PM   #2
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Great article with lots of food for thought. Thanks for posting.
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Old 09-22-2010, 11:59 PM   #3
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Originally Posted by Onward View Post
Here's an interesting discussion of potential dangers in index investing.

FT Alphaville Did nobody ever consider that indexing was dangerous?

The original paper is here, but before you can read it you have to be a purchaser, subscriber, journalist, govt employee, or resident of a developing country.

The (summarized) arguments leave a lot of things unanswered IMO, but it's interesting to consider various flaws in the gospel of indexing, which I adhere to closely.
Seth Klarman (Baupost Group) observed that when a stock is taken into an index, it's price goes up. It follows that when you buy an index fund, you are buying a collection of stocks that have been artificially marked up. Sounds like a brilliant strategy to me!

Ha
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Old 09-23-2010, 12:19 AM   #4
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when you buy an index fund, you are buying a collection of stocks that have been artificially marked up
But only very successful companies get added to the DJIA or S&P 500. You would expect their stock to go up, on average, even after they've been added to an index.

I know there is a usually a small "pop" around the time index membership is announced. But that premium could easliy be diluted in the months and years following induction into the index.
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Old 09-23-2010, 12:34 AM   #5
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I know there is a usually a small "pop" around the time index membership is announced. But that premium could easliy be diluted in the months and years following induction into the index.
Partly that depends on what you call Small. Also, it seems that the premium does persist. AS eveidence of this, when a stock is dropped from an index it tends to fall immediately. If that were just due to an accurate judgment that the company was doing poorly and would continue to do so, the drop would not wait for an announcement of the issue being dropped from an index.

Anyway, many people like index investing, and for them this appears not be an issue. It should be pretty clear however, that the more expensive a stock is, the more of it an index buyer will be buying which somehow just bothers my primitive hillbilly mind. It can't be buying low, unless the entire market is on it's butt.

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Old 09-23-2010, 01:03 AM   #6
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What choice do passive investors have?
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Old 09-23-2010, 04:52 AM   #7
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Interesting concept the index funds become the market.


To me it would seem that the biggest risk is that when a significant number of indexers exit the market for whatever reason, the entire market is pushed down (as opposed to active investors selling the weakest individual stocks)... Index funds/ETFs become the market... or at least the base of the market.


IMO - Indexing will work ok... but one needs to use a system! I think this is where asset allocation and rebalancing shines (while reducing long-term risk). Rebalancing between asset classes (e.g., stocks and bonds) to capture money in good times and redeploy money in bad times is a workable and relatively passive system! It is a contrarian approach to rebalance on the way up or down but it has a built-in buy low/sell high bias. Even if the stock market just moved in a wave pattern over 5-10 year periods with no appreciable gain ( like the last 10 years for the S&P 500)... the mechanics of rebalancing between stocks and bonds would yield a respectable gain in good times with the benefit of less down-side impact in bad times.
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Old 09-23-2010, 06:19 AM   #8
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I must say that Onward has mis-characterized the article. The theme is not about "indexing". Instead it is about "S&P 500 indexing". Thank goodness,

Did nobody ever consider that only fools invest solely in the S&P 500 index?

index investing is not about the S&P500 index. Index investing for many years now has been about owning the entire market of mega, large, mid, small, microcap stocks in both domestic and foreign markets.

The answer to the article's question is that Yes, everybody has looked at how to front-run changes in the S&P500 index and many Russell indexes. No news here.
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Old 09-23-2010, 06:48 AM   #9
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Yawn.

And yet with all of its inefficiencies somehow extremely highly paid, and highly educated, fund managers, with teams of highly paid and highly educated analysts, spending long days doing nothing else but stock selection somehow fail consistently to beat the averages.

Once that changes, then I'll consider indexing to be more dangerous than active management.

And what LOL said.

And one more thought. With an index, I don't have to worry that my genius fund manager (which includes an individual managing his own money) does something incredibly stupid . . . like maybe load up on a bunch of financials that are 'cheap' because they've already declined 50%. It seems the downside risk of any fund manager pooping the bed is generally far greater than whatever slight alpha he could add, even if he could add alpha, which he generally can't.
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Old 09-23-2010, 07:58 AM   #10
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IMO - Indexing will work ok... but one needs to use a system! I think this is where asset allocation and rebalancing shines (while reducing long-term risk). Rebalancing between asset classes (e.g., stocks and bonds) to capture money in good times and redeploy money in bad times is a workable and relatively passive system!
I'd be interested if you (or anyone) has a good study/data on this. I stick to an AA, but I have not been able to convince myself that it routinely provides a bump in gains (I do it to manage risk).

I did a simple (and flawed I'm sure) mock up spreadsheet with a long term bond fund and the S&P, and simulated different rebalancing schemes. What I found is that while rebalancing sometimes helped you to sell high buy low, it also had you selling off all along an extended run up, missing out on a large portion of the gains. And what worried me was that the results were highly dependent on the method used - a small shift in the % point chosen for rebalance actually took you from positive to negative to positive again. You needed to pick the 'right' number (which I'm convinced is a function of history, not any fundamentally correct number). But I'd love to see a rigorous study of this.

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Did nobody ever consider that only fools invest solely in the S&P 500 index?
Well, if one invests largely (not solely) in an S&P index, and realizes that the index isn't a perfect measure of the entire market, but that it seems to track reasonably well (and is OK with that), maybe they are merely a little foolish?

One reason I use (perhaps foolishly) an S&P index is the options on it are highly liquid, and I like to use those as part of my investment approach. I have not looked in a while, but I'm not sure that is the case with some of the broader funds.

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index investing is not about the S&P500 index. Index investing for many years now has been about owning the entire market of mega, large, mid, small, microcap stocks in both domestic and foreign markets.

The answer to the article's question is that Yes, everybody has looked at how to front-run changes in the S&P500 index and many Russell indexes. No news here.
I haven't looked in a while, and while I agree with your assessment (it would be silly to disagree with a fact), I'm not sure there is any meaningful distinction for an investor. IIRC, these are all cap weighted - seems like the differences diminish pretty quickly. But I'm still on my first cup, I could be way off base.

-ERD50
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Old 09-23-2010, 08:27 AM   #11
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I must say that Onward has mis-characterized the article. The theme is not about "indexing".
Well, the article's title is "Did nobody ever consider that indexing was dangerous?" But good point about S&P500 vs total market. Seems to me that total-market indexers should have some of the same concerns though--i.e. index members (even if it's all stocks) being overvalued due to index membership. Also, S&P500 is 80% of the U.S. market and 30% of world markets, so if the S&P500 is overvalued, a big chunk of a total-market index is overvalued.

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It should be pretty clear however, that the more expensive a stock is, the more of it an index buyer will be buying which somehow just bothers my primitive hillbilly mind.
This seems to be the most common criticism of cap-weight indexing lately. But an index that bought the most expensive stocks would be P/E-weighted. The S&P500 is cap-weighted. A large-cap stock is not necessarily expensive, and could be very cheap. A stock who's price is rising is not necesarily getting more expensive on an earnings-yield basis.

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And yet with all of its inefficiencies somehow extremely highly paid, and highly educated, fund managers, with teams of highly paid and highly educated analysts, spending long days doing nothing else but stock selection somehow fail consistently to beat the averages.
This is still the bottom line for me too, but it's good to see the other side.
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Old 09-23-2010, 09:26 AM   #12
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ERD50, you asked about rebalancing and what you write is true: just change the dates or parameters and you get a slightly different result. Here's a study for you (I think linked before):

http://www.tdainstitutional.com/pdf/..._Daryanani.pdf
and
https://institutional.vanguard.com/i...ebalancing.pdf (danger with this one is that it uses too many significant figures without cause)

even so, these papers do not treat one of the ways that I use to rebalance.
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Old 09-23-2010, 09:34 AM   #13
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And one more thought. With an index, I don't have to worry that my genius fund manager (which includes an individual managing his own money) does something incredibly stupid . . . like maybe load up on a bunch of financials that are 'cheap' because they've already declined 50%. It seems the downside risk of any fund manager pooping the bed is generally far greater than whatever slight alpha he could add, even if he could add alpha, which he generally can't.
Some fund managers are just plain bad. Some actually know what they are doing. There are many funds that have a beta below an index beta of 1.0. Are you saying the all the index funds that owned financials escaped unscathed in 2008?
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Old 09-23-2010, 09:45 AM   #14
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I don't have to worry that my genius fund manager (which includes an individual managing his own money) does something incredibly stupid . . . like maybe load up on a bunch of financials that are 'cheap' because they've already declined 50%
'Cause then you wouldn't have a Legg to stand on.
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Old 09-23-2010, 09:46 AM   #15
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ERD50, you asked about rebalancing and what you write is true: just change the dates or parameters and you get a slightly different result. Here's a study for you (I think linked before):

http://www.tdainstitutional.com/pdf/..._Daryanani.pdf
and
https://institutional.vanguard.com/i...ebalancing.pdf (danger with this one is that it uses too many significant figures without cause)

even so, these papers do not treat one of the ways that I use to rebalance.
Thanks, I saved both of them and will study them later.

I just read the OP linked article. What seems to be missing for me is, the author may be 100% correct in the micro observations (how a particular stock reacts to being in/out the S&P500), but is this significant when looking at the S&P500 totals? Since the S&P is cap weighted, I imaging the bottom stocks that move in/out are really small potatoes relative to the whole.

And more relevant to the real world is kcowan's comment:

Quote:
What choice do passive investors have?
Some investors on this forum do their own individual stock analysis and picking. My gut says that should be able to work for an intelligent investor, but I no longer trust my own ability to do that. I'm really more comfortable with index funds, even if they have a few warts. The devil you know...?

-ERD50
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Old 09-23-2010, 09:54 AM   #16
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Yawn.

And yet with all of its inefficiencies somehow extremely highly paid, and highly educated, fund managers, with teams of highly paid and highly educated analysts, spending long days doing nothing else but stock selection somehow fail consistently to beat the averages.

Once that changes, then I'll consider indexing to be more dangerous than active management.

And what LOL said.

And one more thought. With an index, I don't have to worry that my genius fund manager (which includes an individual managing his own money) does something incredibly stupid . . . like maybe load up on a bunch of financials that are 'cheap' because they've already declined 50%. It seems the downside risk of any fund manager pooping the bed is generally far greater than whatever slight alpha he could add, even if he could add alpha, which he generally can't.
+1

I have read about the pop of going into an index over a decade ago... so it is not new... Now, this one seems to say that once in the index they start to lose their individuality and move more with the market than one would think if they were not in an index... might be true... but once you get large enough you do start to follow the market....


And like G4G said, how come the smart people that charge a lot of money to pick stocks can not make money KNOWING this is true Also, how much of this is caused BY the people trying to make some money KNOWING that the stock has to get into the index and purchased by all the index funds and front runs it
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Old 09-23-2010, 10:00 AM   #17
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I'd be interested if you (or anyone) has a good study/data on this. I stick to an AA, but I have not been able to convince myself that it routinely provides a bump in gains (I do it to manage risk).

I did a simple (and flawed I'm sure) mock up spreadsheet with a long term bond fund and the S&P, and simulated different rebalancing schemes. What I found is that while rebalancing sometimes helped you to sell high buy low, it also had you selling off all along an extended run up, missing out on a large portion of the gains. And what worried me was that the results were highly dependent on the method used - a small shift in the % point chosen for rebalance actually took you from positive to negative to positive again. You needed to pick the 'right' number (which I'm convinced is a function of history, not any fundamentally correct number). But I'd love to see a rigorous study of this.



Well, if one invests largely (not solely) in an S&P index, and realizes that the index isn't a perfect measure of the entire market, but that it seems to track reasonably well (and is OK with that), maybe they are merely a little foolish?

One reason I use (perhaps foolishly) an S&P index is the options on it are highly liquid, and I like to use those as part of my investment approach. I have not looked in a while, but I'm not sure that is the case with some of the broader funds.



I haven't looked in a while, and while I agree with your assessment (it would be silly to disagree with a fact), I'm not sure there is any meaningful distinction for an investor. IIRC, these are all cap weighted - seems like the differences diminish pretty quickly. But I'm still on my first cup, I could be way off base.

-ERD50

I agree that it is probably not going to achieve theoretical maximum gain. But for most of us... it strikes a good balance between getting a decent gain and mitigating the downside risk.

People often cite Japan as an example... Perhaps that may not happen to the US... but if it did and we had a 20 year down turn... it makes sense.

Look at the NASDAQ... mega-bubble run up. It might take 20 years for it to achieve its past lofty high.

If stocks are having a good long run, the use of bonds are likely to reduce the comparative total return. However, when thing start getting bad... they show their value.


You mention letting stocks run... AA and rebalancing back to a target allocation (e.g. 60/40) accomplishes that goal to a certain degree.

I think it is a trade-off. Look at it as an opportunity cost for risk reduction (like insurance).

If we had the benefit of knowing what was going to happen in the future... we would be all in or all out. Without it, most of us rely on a system.
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Old 09-23-2010, 10:18 AM   #18
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One of the better explanations of the value of indexing:
I don't know and I don't care - Aug. 29, 2001
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Old 09-23-2010, 10:28 AM   #19
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One of the better explanations of the value of indexing:
I don't know and I don't care - Aug. 29, 2001
Wonder if he still feels that way?
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Old 09-23-2010, 11:28 AM   #20
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Wonder if he still feels that way?
Yup. The Intelligent Investor: Why Funds' Hot Performance Isn't So Hot - WSJ.com

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