Is indexing good?

[Gone4Good]

Quote:

Originally Posted by grumpy Unless this is an IPO or secondary offering, how is the cost of capital lower for THE FIRM?* Most stock buys/sells are between investors and do not directly effect the firm. * Grumpy

Companies issue shares all the time, through DRIP plans, through stock awards and options, sometimes to finance large capital spending plans and especially for M&A. Many companies merge simply by exchanging shares without ever having to hold a secondary offering. A perfect example of this is AOL buying Time Warner in a share exchange in 2000.

Perhaps more importantly though, stock prices feed into companies' estimates of their weighted average cost of capital (WAC). The WAC is the hurdle rate companies use to evaluate internal investment decisions. If the stock price is "wrong" due to market inefficiencies then the company's hurdle rate will also be wrong and capital will be spent in ways that actually destroy value.

[sgeeeee]

Quote:

Originally Posted by Apocalypse . . .um . . .SOON . . .* It gives the best argument against indexing I've seen.* . .

All I can say is if this is the best argument against indexing, then there is no reasonable argument against indexing.

As long as index funds continue to beat 75% of active funds over 10 year periods and more than that over longer periods, arguments against indexing are nothing but hand-waving. Wake me up when that actually starts to change.

[grumpy]

Quote:

Originally Posted by . . . Yrs to Go Companies issue shares all the time, through DRIP plans, through stock awards and options, sometimes to finance large capital spending plans and especially for M&A.

For companies in the major indices, like the S&P 500, these types of share issuances represent an infintesimal percentage total shares outstanding and so do not have any substantial impact on a company's capital structure.

Grumpy

[greg]

Quote:

Originally Posted by justin Apocalypse, I failed to see your point re: GE being owned in large quantities by index funds. The "Major Holders" listing you linked to at Yahoo Finance showed that of the top ten mutual fund holders, only 3 were index funds. That means 7 actively managed funds are making big bets on GE. Are you saying that a minority position (that which is owned by index funds) is causing huge distorting effects and inefficiencies in the capital markets?

Justin:

No, I'm saying everyone else is just doing "the pile on" with other monies and other related but different strategies. I'm working on a better response. Most everyone here wants some sort of absolute, statistically verifiable, hard truth response. It won't be that--because currently the numbers won't/can't show it. Remember what the article says: indexing works until it doesn't--just like the housing bubble, just like the tech boom. Some got off at the right time, some didn't. The statistics and numbers and reported facts looked great as the tech bubble was going up. I'm currently playing the near term natural gas pile on and the longer term gold pile on. The mid term oil pile on doesn't look to risky to me either--but that one is more of a worrier to me. I think a lot of the old Ben Graham-type values are gone from the market place at this point. Just speculation, but perhaps the only thing left in the world are future pile on situations.

I guess another way of saying it is "expect volitility down the road." But that would be a very extreme take on things that even I don't believe. But many non-bears have said it. I'll be back.

[Gone4Good]

Quote:

Originally Posted by grumpy For companies in the major indices, like the S&P 500, these types of share issuances represent an infintesimal percentage total shares outstanding and so do not have any substantial impact on a company's capital structure. * Grumpy

Are you arguing that current equity prices do not impact a company's cost of capital? If so, I respectfully disagree.

[grumpy]

Quote:

Originally Posted by . . . Yrs to Go Are you arguing that current equity prices do not impact a company's cost of capital? If so, I respectfully disagree.

I was under the impression that most major corporations raise capital (when the need arises) by issuing debt, not equity. Therefore I don't see how equity prices have a major impact on cost of capital.

Grumpy

[Gone4Good]

Quote:

Originally Posted by grumpy I was under the impression that most major corporations raise capital (when the need arises) by issuing debt, not equity.* Therefore I don't see how equity prices have a major impact on cost of capital.

I think we may be coming at this from two different perspectives - mine perhaps a bit more theoretical.

Even if a company does not issue any additional equity in a given year, there is still a theoretical cost of the equity (including retained earnings) currently used to finance the company's existing assets.* How do you judge whether an existing asset creates value for shareholders?* Simply earning a positive return is not enough.* To add value an asset must earn an unlvered return at least as high as the firm's theoretical cost of equity.* Unfortunately, equity does not come with a price tag so the cost must be estimated.* Depending on the model current equity prices or equity beta are used as a basis for this estimate.

I'm not sure how clearly I've explained myself.* However, my basic point is that market data is used to estimate a firm's cost of equity and that companies rely on that estimate in making corporate finance decisions.

[greg]

. . . Yrs to Go:

Thanks for your explanation; it’s very helpful. But I see Mauldin differently. Your second paragraph has a couple issues packed in that bother me slightly. First of all, I don’t see Mauldin as just someone who just advocates active investment management, just as Warren Buffet is not any old active portfolio manager. He looks into markets and sees things that are important for investors to know, and I think he does it better than most. You gathered him up in a bag with all the other active managers and implied they are all bag-ettes .

Secondly, I think you belittled his macro-allocation insight. You said “it is the prevalence of indexing (both overt and covert) that causes the market's inefficiency” and then swept that away too. His argument, as I read it, is that indexing takes on a life of its own, becoming a positive feedback loop for even more indexing that works until it doesn’t, until the money starts to flow out and fewer people like it, in one possible instance. This is an important event that explains a part of the reason why index funds and the stocks that underlie them behave the way they do.

I’d like to step away and examine another market sector or actually non-market sector that behaves somewhat similarly to how the indexing ‘positive feedback loop’ works. This could shed some light on indexing, which is on a separate (but related), longer-term cycle

I see the current house price market as containing a mixture of both efficiencies and inefficiencies. The inefficiencies are basically macro in nature: housing prices are just too high all over the place. They are especially high in some areas of the country such as on the west and east coasts. In the mid-west and some pocket areas they are less over priced. I hope most people here would agree with me about that.

One could say that the current housing market is having a macro misallocation problem. Housing is too expensive in general and mostly in the particular too. We can give many good reasons for this misallocation problem that has occurred over the past few years—for argument’s sake—the long run. Everybody here has seen and/or discussed them many times.

We’ve also discussed the micro problem: “Boy, those dang houses are expensive right now.” In most cases each individual that buys a house in our current market is operating efficiently: He or she looks at houses, finds one they like, and negotiates a price that makes them at least reasonably satisfied. They look at comparables that say whether or not the particular house they like is of fair market value. They talk to the bank about how much they can borrow and then spend on a house. They determine if their wages or whatever can support the payments. Then they may start the thinking process of whether it is worth it. Sometimes they have a lot of profit in their current house, which not only says to them that buying a big McMansion has been good in the past it is probably good in the future. Lots of money to be made and nice living in housing. The individual buyer (and the seller) is operating efficiently in the housing marketplace, buying at the best possible price at the time—or so it appears--at that time. Pretty soon, people are just buying real estate on the momentum—a positive feedback loop starts and takes on a life of its own—until it doesn’t.

I, personally, see a great deal of inefficiency in each individual act of buying and selling by ‘rational’ people. This can be examined too: old fashioned value investors in homes will have a tendency to back off from buying at these times—or they sell making them active participants too; growth investors may jump in hog wild, buying more home than they need in anticipation of early retirement or some such other event. This has happened before in other types of markets. So, my question becomes: Can a long (three years?) accumulation of inefficient—yet apparently rational--individual behaviors give rise to an efficient market overall? One doesn’t need more than 50% of people, or some such other quantifiable event, to own or be buying such products to move the market in a particular direction either.

I think the same insight Mauldin offers in his article can be applied to many so-called efficient markets. But each must be applied carefully to particular circumstances to find out if this is true.


What Mauldin offers, although not in detail in a four page article he borrowed, is far more than what you suggest--to my mind. He offers a valuable tool in evaluating financial markets in general, although I am extending this idea further than he might. You said “his argument is essentially no different than that of anyone else who advocates active investment management.” I think you have painted him with too broad of a brush. He has gone into a fair amount of detail about how this macro-misallocation works in the stock market. Having such details and working out specific applications for individual usage, gives one a fair amount of power in determining where, when, and how to allocate ones resources—and how to see the world a little differently. I think you summarized incorrectly, IMO

And, of course, if the housing bubble never breaks but continues to expand then I’m wrong. Or right, but my timing model doesn’t work.

[sgeeeee]

Fund Indexers, Take (Another) Bow

http://online.wsj.com/public/article...nal_primary_hs

“. . . Most performance-hungry investors don't own just one actively managed fund. Rather, they own a whole fistful of funds -- and with every fund they add, the odds against them grow steeper. . .

“. . . As the record of Vanguard 500 suggests, an index fund will beat roughly three-quarters of comparable actively managed funds over any 10-year stretch. For market junkies, those don't seem like daunting odds. After all, with a little work, they should be able to make it into the top quarter, right?

That might be true if these market junkies were buying just one fund. Problem is, to build their desired portfolios, investors often purchase five, six or even a dozen funds.

Moreover, most of us are investing for a lot longer than 10 years. Figure in those two factors, and suddenly the odds of winning become almost insurmountable. . .

“. . . the more funds you pick and the longer the time period, the worse the odds get. . .

“. . .Suppose, instead, that the two sets of competing portfolios consist of five funds. Suddenly, the odds of an actively managed-fund portfolio beating an indexed portfolio shrink to 35% over one year, 18% over five years, 12% over 10 years and just 5% over 25 years. . .

“. . . the odds of beating an indexing strategy would look even worse if you figured in taxes and investors' bad timing. . ."

[BUM]

CHP: Can I buy a vowel?

[sgeeeee]

The Arithmetic of Active Management

http://www.stanford.edu/~wfsharpe/art/active/active.htm

“. . . Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement. . .”

[greg]

And don't forget one of the best reasons for keeping money in popular index funds right now: All the retirement money pouring into them. This is very much a positive for indexing. Making money for retirement is a good thing.

[Gone4Good]

Quote:

Originally Posted by Apocalypse . . .um . . .SOON I think you have painted him with too broad of a brush.* He has gone into a fair amount of detail about how this macro-misallocation works in the stock market.* Having such details and working out specific applications for individual usage, gives one a fair amount of power in determining where, when, and how to allocate ones resources—and how to see the world a little differently.* I think you summarized incorrectly, IMO And, of course, if the housing bubble never breaks but continues to expand then I’m wrong.* Or right, but my timing model doesn’t work.* *

Apocalypse,
I must have missed something because I didn't see anything in the article that would give one "a fair amount of power in determining where, when, and how to allocate ones resources". Are you referencing other sources than the one you linked to the original post?

Quote:

His argument, as I read it, is that indexing takes on a life of its own, becoming a positive feedback loop for even more indexing that works until it doesn’t, until the money starts to flow out and fewer people like it, in one possible instance.

I don't see any sign that indexing has "stopped working" as Maudin suggests, and he provided no evidence in his article (maybe he supports this thesis elsewhere). I also see no evidence of a "positive feed back loop" caused by index funds that drove market prices higher. His quote:

Quote:

As the late 1990s craze showed, indexation is a guarantee for capital to be wasted

is over the top. Again, maybe he supports this thesis elsewhere but to blame indexing on the speculative frenzy of the late 90's is completely counter to my recollection of what happened. I don't recall Pets.com finding its way into the S&P 500.

Mauldin also seems to view hedge funds as a symptom of a problem, but I think the reality is that hedge funds are an outgrowth of an increasingly efficient market exploiting new technologies and techniques to further arbitrage away market inefficiencies. Mauldin's comparison of today's hedge funds with active investment managers of 'yesteryear' is misplaced. Hedge funds are doing things today that Peter Lynch's Fidelity Fund could never do. Capital markets are MORE efficient as a result, which bolsters the case for indexing. I saw nothing in Maudin's essay that would support a different conclusion.

[greg]

. . . Yrs to Go: Thanks for answering. Much of the problem may be my fault in not making clear conections. I'm sorry if that's the case. I'll start this way if you don't mind (in a related or unrelated case--to be determined) :

So, do you think we are in a residential real estate bubble right now? If yes, do you see any signs of it that can be measured? If no, do you think any sort of financially-related bubble is possible?

I'm just trying to define/understand terms, so we start on the same page.

[sgeeeee]

Quote:

Originally Posted by Apocalypse . . .um . . .SOON . . . So, do you think we are in a residential real estate bubble right now?* If yes, do you see any signs of it that can be measured?* If no, do you think any sort of financially-related bubble is possible? I'm just trying to define/understand terms, so we start on the same page.*

Greg,

This article seems like baseless nonsense to me. And how do these questions about real estate relate to anything?

Can you express one of your concerns about indexing in 25 words or less? What really worries you?

[ladelfina]

I don't understand how hedge funds help with 'efficiency'; I thought their bug/feature was the fact that they were into a lot of obscure and IL-liquid areas.


Second, the "bubbles" seem to me like gas in your stomach (sorry, this isn't the bean thread, I know!). There's a LOT of money out there and it needs to go somewhere. When people are scared of stocks, it goes in to RE; when people are scared of RE, it goes into stocks/bonds. It burbles around.

What happens when people are scared of everything? It goes under the mattress? You burn it in the fireplace to keep warm? I guess these people are the 'gold bugs'.

The only thing that would make stock indexing undesirable would seem to be a 1930's-style crash... if you think the regulatory environment is as messed up as it was then.

Seems if you are afraid of pure indexing being too overweighted WRT market cap, then you could roll your own index investments into more foreign and small/micro cap indexes and still benefit from indexing. Or am I wrong?

[greg]

Quote:

Originally Posted by ((^+^)) SG Greg, This article seems like baseless nonsense to me. And how do these questions about real estate relate to anything? Can you express one of your concerns about indexing in 25 words or less? What really worries you?

SG: I think YTG and I are having definition problems, but currently we are only dealing with side issues. My guess at this point is that he may think that ALLl markets where a buyer and seller agree on a price (and complete a transaction) is a rational and efficient market. Inquiring minds need to know, otherwise we end up arguing about nothingnesses.

ladelfina: I like your definition of bubbles. And unlike Allen Greenspan I think they are rational entities that can be understood and acted upon while they occur. But, then again, I think everything understandable has an element of rationality to it, or it couldn't be understood. I need YTG's basic definitions to start.

SG: This may help: I tend to speak-think in experiential syllogistic patterns: For example, someone once said they saw Trombone Al on the grass while at a rumage sale (actually the person was reminded of T-Al while looking at a trombone). This amused me. Later, I was on jury duty and the judge started talking about facts and it reminded me of a Nord's comment the nite before.
Therefore:

The judge talks about facts
Nords talks about facts
Nords is the judge. (to my mind, but not really )

Sometimes I confuse what is going on in my mind with reality. But sometimes I don't. YTG can help me find out if I'm wrong.

[justin]

Greg, get a grip! You're sounding crazy! Has Martha been feeding you mind-altering substances? Is there a gas leak in your basement??

[REWahoo]

Quote:

Originally Posted by Apocalypse . . .um . . .SOON Sometimes I confuse what is going on in my mind with reality.

Martha, if you haven't been feeding Greg mind altering substances, then you should be.

There are a number of excellent medications on the market that can help. Many of us on the forum have grown to admire and respect you and it pains us to know what you are enduring. We all know that a mind is a terrible thing to waste and Greg's is surely wasted.

And if he won't take the meds, then YOU take them. One way or the other, you will get some relief.

[MJ]

Quote:

Originally Posted by REWahoo! Martha, if you haven't been feeding Greg mind altering substances, then you should be. There are a number of excellent medications on the market that can help. Many of us on the forum have grown to admire and respect you and it pains us to know what you are enduring. We all know that a mind is a terrible thing to waste and Greg's is surely wasted. And if he won't take the meds, then YOU take them. One way or the other, you will get some relief.

Man REW, you are sharp and wicked.