What happens when everyone is using index funds?

[photoguy]

Perhaps here the analogy to a casino is apt it is the House that gets the excess returns i.e. the managers of the funds.

I remember reading a paper by Fama (?) that showed any excess alpha of mutual funds going to the fund manager in increased expense ratio.

 

[Texas Proud]

Indexers' return is the benchmark, and we use the market return as the benchmark. So, indexers cannot get the excess that losers give up. Indexers do not trade, remember?

I think it is really the "smart money", the better organized institutional investors, some of whom I listed above, who got the bulk of the money from loser individual investors.

PS. I remember that indexers who rebalance also get some excess return over somebody who just holds. But of course that's true only during market gyrations. In a long steady bull market climb like 1980-2000, buy-holders win big over rebalancers. It's not that simple, eh?

You keep forgetting the big vig that the investment industry takes out of the game each and every day....

Also, the indexes are just that... an index... if the DOW goes up 10% it does not mean that wealth went up 10%.... the DOW is a dollar weighted index and if a cheap stock like CSCO goes up, it does not have as much impact on the index as McDonalds.... but McD has less market cap than CSCO.... not the same with other indexes.... but they probably have some issue also....


Last.... IIRC, the question arose about indexing vs other mutual funds... so that is what I was answering....

 

[NW-Bound]

No, I do not forget the friction loss that MF managers or the trading houses take.

However, I am under the impression that active [-]investors[/-] MFs trail the index a lot more than the 1 or 2 percent that is the expense ratio. If so, how is the missing amount accounted for?

The S&P 500 is market-cap weighted, and does reflect very closely the percentage movement of the entire equity wealth. It is still missing the smaller cap stocks, but I remember reading that these are not significant compared to the giants.

PS. I had to change the word "active investors" to "active MFs" as they should not be used synonymously.

 

[ERD50]

...
However, I am under the impression that active investors trail the index a lot more than the 1 or 2 percent that is the expense ratio. If so, how is the missing amount accounted for? ...

Isn't the explanation that Texas Proud and I gave a possible answer? The X% is already in the indexes?

So if an active investor buys high and sells low, every fund/pension following the index is buying as part of investing deposits and payroll deductions as part of normal business.

I wonder how the actual algorithms work in an S&P 500 index fund. Do they really own all 500? I would think yes, if they are big they don't want their buys/sells to flood the market - concentrating in a sample would cause that to happen to an extent. When do they re-balance? Is there a forum for index fund managers where they endlessly debate re-balancing strategies?

But if a stock drops, and all the index funds need to sell it, doesn't that cause it to drop further, causing them to have to sell more? Sounds like a run-away freight train (or thermal runaway). So maybe they only rebalance occasionally, and all out of sync from one another? Sounds like it is the indexes that might be buying high and selling low?

At any rate, few active funds surpass the index, so for now it is academic.

-ERD50

 

[NW-Bound]

First, please note the correction I made in the post that you reply to. That is, I strongly believe one cannot use the performance of active MFs to judge all active investors.

In an earlier post, I name several classes of active investors that are not active MFs: individual stock owners, hedge funds, pension funds, endownment funds, investment banks, sovereign funds, etc... How do they do? If they do well, where's that money coming from?

Isn't the explanation that Texas Proud and I gave a possible answer? The X% is already in the indexes?

But, let me rephrase your statement to see if I understand it. You were saying that the active MFs who are losers somehow boost up the return of the market, enriching the indexers or even buy-holders even if the latter do not trade.

There have been many actions of the financial industry that have caused harm, meaning taking away from the market. It is easily seen how the market could be higher if there were no financial fiasco caused by CDO, CDS, and all that crap, resulting in huge amounts of government money to bail them out (and much went into their pockets as salaries and bonuses). These deleterious effects take away from the market, actually the whole economy, and hurt everybody, whether you trade actively or not. They cause the index to go down.

Now, I am trying to see how active traders or stock pickers do the reverse to the market, boosting it up so that even buy-holders can benefit. I cannot see how though. I can see how they enrich the MF managers and the stock exchanges, but not the non-traders.

So, how about the other "active investors" I described, the one who are not "loser active MFs"?

 

[Texas Proud]

First, please note the correction I made in the post that you reply to. That is, I strongly believe one cannot use the performance of active MFs to judge all active investors.

In an earlier post, I name several classes of active investors that are not active MFs: individual stock owners, hedge funds, pension funds, endownment funds, investment banks, sovereign funds, etc... How do they do? If they do well, where's that money coming from?



But, let me rephrase your statement to see if I understand it. You were saying that the active MFs who are losers somehow boost up the return of the market, enriching the indexers or even buy-holders even if the latter do not trade.

There have been many actions of the financial industry that have caused harm, meaning taking away from the market. It is easily seen how the market could be higher if there were no financial fiasco caused by CDO, CDS, and all that crap, resulting in huge amounts of government money to bail them out (and much went into their pockets as salaries and bonuses). These deleterious effects take away from the market, actually the whole economy, and hurt everybody, whether you trade actively or not. They cause the index to go down.

Now, I am trying to see how active traders or stock pickers do the reverse to the market, boosting it up so that even buy-holders can benefit. I cannot see how though. I can see how they enrich the MF managers and the stock exchanges, but not the non-traders.

So, how about the other "active investors" I described, the one who are not "loser active MFs"?

I will put out a guess.... based on nothing at all....

Your example is looking at the market as a closed loop... in other words, there are only say 100 investors.... and all 100 are in the market.... nobody comes in and nobody leaves.... that just isn't so...

During the last crash, many people left the market... or they cut their equity investment % down.... so they could be active, but lost out on the gain.... so a few active investors bid up the stock... remember, only a small % of people sell their stock.... so someone bids a stock up from $90 to $100... someone took that $10 gain out of the market... but everybody who owns that stock now has $10 more money then they did before the gain.... including all the passive investors... so one trade made everybody richer...


Now... here is a question that just popped into my brain.... how often does the market turn over in a year IOW, if you added up the price of all the shares sold in a day, how many days would it take to equal the whole value of the market

 

[NW-Bound]

I have to mull over your first statement.

About the question, in a typically trading day, a big and widely held stock like IBM or Intel has less than 1% (0.5-1%) of outstanding shares changing hand. So, if all stocks are like that, it is roughly about 1 year or less for a complete market ownership change-over.

For reference, Wellesley portfolio change-over is shown by Morningstar as 109%/yr. It used to be lower, around 30-40%, as I remember.

Holy cow! Compared to me, these guys are day traders. If I trade like that, I would be churning my entire investable assets each year, and I am certainly not doing that.

 

[Texas Proud]

I have to mull over your first statement.

About the question, in a typically trading day, a big and widely held stock like IBM or Intel has less than 1% (0.5-1%) of outstanding shares changing hand. So, if all stocks are like that, it is roughly about 1 year or less for a complete market ownership change-over.

For reference, Wellesley portfolio change-over is shown by Morningstar as 109%/yr. It used to be lower, around 30-40%, as I remember.

Holy cow! Compared to me, these guys are day traders. If I trade like that, I would be churning my entire investable assets each year, and I am certainly not doing that.

Yea, most of the shares sold in a day are program trading, trying to get a penny or so out of each share.... throw in all the day traders and I bet it is a big majority of the market... I am sure that the volume of 'real' investors would be much less.... heck, maybe a complete turnover in 3 to 5 years.... (again, just a WAG...)....

 

[gcgang]

+

I don't get Running Man's $320k zero... if $320k grows to $1 million over 10 years that is a 12.1% annual rate of return.... let me know where I can buy that zero and I'll jump all over it.

I think he must've activated the time machine and gone back to 1982.


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