What happens when everyone is using index funds?

[Alan]

That is an interesting experiment and incorporates some of what goes on in the markets. But it misses some things I can think of like (1) momentum effects, (2) the value premium, and (3) the small growth negative premium due to the asset class's lottery like character.

It wasn't actually an experiment on the markets it was an experiment on human behavior which some finance reporter picked up and equated to human behavior in the market when it comes to DIY or index funds.

You could apply the results to other aspects of life.

 

[NW-Bound]

If I keep pushing my idea of "political indexing", and tell people to not bother to vote and just to rely on the political active factions to decide at the poll, will I become a hero for saving John Doe the trouble of trying to figure out the issues, and to see what's right or wrong? Why can't he just accept the "wisdom of the masses"?

... I am going out on a limb and postulating that many "index investors" think of themselves as above average because they are relying on backtest results that say they are likely to beat the stupid money that trades a lot. I'm not saying they are wrong, just that many index investors do not think of themselves as "just average".

Regarding the OP, there is the whole question of "what index"? There are so many indexes out there. Some people trade indexes. And ETF's are just baskets of stocks, why not flip them? That's what many do. Have you guys heard that biotech is hot? Buy a biotech ETF to protect yourself from individual stock risk.

You can probably tell I'm having fun with this. Please don't take me too seriously (but I'm above average).

Me too! But I do want people to think about what I pointed out.

Now, it is true that many investors trail the indexers. How many people never owned stocks in their life, but scraped up some money to buy dot-com stocks? I still recall around 1998 a story of people gathering up family heirlooms and selling them for the gold content in order to get money to buy stocks.

Indexing gives one a safety margin of diversification. But as Lsbcal points out, there are many indices: growth vs. value, small vs large cap, US vs international, developed vs emerging markets. Most indexing investors still have to decide how to weigh each of the above components. Stock vs. bond vs. cash?

So, indexers like to claim better performance, but which index are they talking about? And over what period?

Now, I agree that the market overall is reasonably efficient and rational. If a stock is priced at a lower or higher P/E than another, there's a reason for it. If you bet against the market, saying that this stock should be priced higher or lower, you would better have a good rationale. And even so, your hypothesis often turns out wrong.

But it causes me to itch when people take this "efficient market" to the extreme, and think that the market is this super-smart entity that can never be wrong. How can one then explain repeated bubbles and crashes? Did you ever allow yourself to question if the market could be wrong during the dot-com era or the more recent real estate bubble? See no evil, hear no evil, talk no evil?

In the political arena, with the "wisdom of the crowd", why did the world have terrible rulers in the past who had the popular support? Currently, Putin has the majority support of his people, despite bringing his country to ruin. The masses are not always right, in stock or in politics.

 

[Running_Man]

I guess we will just have to wait for the next update in the Buffet bet of the index versus the hedge-fund. So far, it isn't looking good for all the sophisticated people at those hedge funds who try to determine the best places to put their money ('your money'? do they put 'their money' in the funds they sell?).

Looks like this bet might be one of their less than optimal choices?

-ERD50

What about the hedge fund managers that are recently partnering with Warren?

 

[meierlde]

We have two different markets involved here, 1 that does not include control of a company by small investors and one where one of the aims is to acquire control of a company. If a companies stock out of wack in a way that a control investor can make money they will get involved. In the case of overvalued stocks the gamblers who like to short stocks will get involved. I suspect that folks who use the market to gamble won't ever go for indexing as the thrill is gone.

 

[ERD50]

What about the hedge fund managers that are recently partnering with Warren?

Tell me more.

-ERD50

 

[robertf57]

True, but "the total market" would do worse and worse. Without the discipline of active investors looking for undervalued stocks to buy and selling stocks they believe to be overvalued, the prices of equities would get increasingly disconnected from reality. Good young companies with smart ideas would be starved for investment capital and grow very slowly, and inefficient lumbering dinosaurs would continue to have their overly-high stock prices supported by the "auto-buy" indexers. The winners would be private capital and private companies--they'd produce better and better returns compared to the increasingly value-blind, fat public equity market. The companies in the public equity market would have falling dividends while private companies and those funded outside the public equity sphere would produce increasingly attractive returns for their owners.

Be thankful for active investors--but don't feel obligated to join them.

Not certain I wholly agree with this. All the world's equities are not held by passive investors. Active owners hold a significant portion of stock (particularly of those smaller companies). In the ridiculous extreme I agree that if absolutely everyone held passive index investments there wouldn't actually be a market; but, even a small amount of market based trading by other sorts of investors and through M&A/divestitures should lead to "appropriate" pricing. Remember that only a fraction of the shares of any equity routinely trade on a given day. Within the sample space of reality, this isn't a concern IMHO

 

[Running_Man]

Tell me more.

-ERD50

Warren Buffet just bought a private placement partial stake into a company Axalta that is primarily owned by Carlyle Group, the group that coined the phrase. He has also partnered with 3G Capital, a private equity group, in buying shares in Heinz/Kraft Foods and the Tim Horton/Burger King deals. These are both companies of the type he has actually criticized as vultures looking for an exit strategy as soon as they purchase.

Most interestingly on the bet, which was actually only 320 thousand, which was the S&P500 would beat the Hedge Fund managers was each side would put the 320 thousand into a zero coupon bond that would then come to the million dollars at the end of ten years. The conservative "sure" zero coupon bond far outperformed both sides of the equity bet the S&P500 and the hedge fund managers so that in 2012 after 4 years into the bet the bonds had each become worth over a million dollars so they sold them and placed the proceeds into Berkshire Hathaway class B stock with Warren personally agreeing to match any shortfall if the value fell below 1 million. Presently that is now worth 1.6 million dollars or the "safe" bet is up 150% from 2008, S&P 500 side of bet is up about 70 percent and hedge fund managers up 20 percent.

 

[Totoro]

Warren Buffet just bought a private placement partial stake into a company Axalta that is primarily owned by Carlyle Group, the group that coined the phrase. He has also partnered with 3G Capital, a private equity group, in buying shares in Heinz/Kraft Foods and the Tim Horton/Burger King deals. These are both companies of the type he has actually criticized as vultures looking for an exit strategy as soon as they purchase.

As far as I know 3G Capital doesn't divest. Probably why Buffet teamed up with them. They are still majority owner in Heinz, Kraft, Tim Horton, Burger King and AB/Inbev. So the vulture label doesn't apply. And from my own network I can tell these guys don't raid & dump. They do go in and shake things up seriously, like firing half or more of the senior management. They basically re-invented zero based budgeting as well. Buffet supplies capital, not management. 3G provides that.

Don't know the Axalta story, what I gather from the press release is that Buffet bought the shares from Carlyle shortly after an IPO. So it's not a partnership as with 3G, just a transaction where it's easier to buy directly vs. open market. He might disapprove of Carlyle (don't know), doesn't preclude dealing with them on favorable terms.

[Edit] Just to be precise: 3G Capital isn't a hedge fund, it's a private equity firm that goes hands on with the company. Big difference.

 

[Totoro]

I'll take a stab at it. Shares owned by totally passive index funds can be deemed for most purposes as non-participating in the market.

Let's simplify into the extreme at first:

• Only 2 publicly listed companies, A & B, same profit, same revenue, same business. Perfect clones.
• Only 10 investors, each have the same amount of money
• All investors have to choose between one of those companies in any proportion but have to be fully vested at all times.
• All just want to optimize financial return in the long run.

Let's say you start with all investors actively trading. Then one day everyone wakes up and converts to indexing.

What happens is that all trading will stop, and prices will stay the same forever, regardless of company performance. Probably A & B will have roughly the same market cap given their start situation.

... some years later company B doubles its profits, A stays the same.

One investor wakes up and says, B should be worth double. He wants to buy B shares and sell A shares .. but there is no-one to buy it from! The market is illiquid. Another investor wakes and thinks the same ... no difference. Still no-one to sell A to, no-one to buy B from.

In fact, it takes an investor with an active opinion (say #3) that believes B is actually worth less than double, and A worth more the original price to get a transaction going.

This shows that for purposes of relative price setting you only need a handful of traders to agree on price. The degree to which those traders differ in their valuation of both companies determines volatility, nothing else. So you can have >90% of the market being indexed, makes no difference. It also doesn't have any direct impact on volatility.

What happens to the indexer? basically nothing. if A goes down and B goes up by shifting capital, it doesn't make any difference as long as he holds his own position. In fact, his return has nothing to do with the relative prices of A vs. B. His return comes strictly from dividends paid out by both companies.

Going further things are of course not that simple.

But what does remain in my view is that there seems to be nothing inherently true that a large passive indexing market has to be less efficient.

It may even become more efficient, as only the very best qualified active traders remain in the market and competition among them becomes ever more intense.

Just my two cents.

 

[gcgang]

Your point is well taken... the results of index investing is not 'average'.... it is 'above average'.... IOW, people who invest in managed funds do worse... some a lot worse... so if you take 100 people and the index investor beats 90 people who invest in managed funds, that is not 'average'....

By definition, index investing does the average less the index expense. But doing slightly less than average, a C-, looks pretty good when most everyone else is flunking.


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[NW-Bound]

By definition, index investing does the average less the index expense. But doing slightly less than average, a C-, looks pretty good when most everyone else is flunking.

If indexers get the average, and if it is true that most active investors get less than average returns, then somebody is getting the above average returns in order to balance out.

I brought up this puzzle before, but do not remember if anyone ventured a plausible answer.

 

[Texas Proud]

By definition, index investing does the average less the index expense. But doing slightly less than average, a C-, looks pretty good when most everyone else is flunking.


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No, you are looking at the return... not the relative position of an investor...

Take 10 investors.... say the indexer matches the avg of the index... but all active investors do not come close... that means the indexer is the 'best' investor of the bunch.... he is not 'average' at all...

Now say the indexer matches the avg of the index.... but all active investors beat the index... now our indexer is the worst investor of the bunch... again, not 'average'.....


History shows that the indexer will beat active investing about 90% of the time... I think getting a 90 means an "A", not a "C"....

 

[CaliforniaMan]

No, you are looking at the return... not the relative position of an investor...

Take 10 investors.... say the indexer matches the avg of the index... but all active investors do not come close... that means the indexer is the 'best' investor of the bunch.... he is not 'average' at all...

Now say the indexer matches the avg of the index.... but all active investors beat the index... now our indexer is the worst investor of the bunch... again, not 'average'.....


History shows that the indexer will beat active investing about 90% of the time... I think getting a 90 means an "A", not a "C"....

+1

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[urn2bfree]

If indexers get the average, and if it is true that most active investors get less than average returns, then somebody is getting the above average returns in order to balance out.

I brought up this puzzle before, but do not remember if anyone ventured a plausible answer.

Some active investors just by chance will get above average some years. The knock on active is not than none of them ever do better than average. The knocks are:

1)MOST do worse than average or average at best and cost more doing it
2)None (practically) can consistently do better than average. A recent study showed 0.28% of funds remaining within the top 25% over the last 5 year period... http://www.spindices.com/documents/spiva/persistence-scorecard-june-2014.pdf
3)It is impossible to guess year to year which ones will do better- so given #1(above), the odds are you will pick wrong more often than right

Hence the smart money bets on Indexing...



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[gcgang]

If indexers get the average, and if it is true that most active investors get less than average returns, then somebody is getting the above average returns in order to balance out.

I brought up this puzzle before, but do not remember if anyone ventured a plausible answer.

Its me. Me, Warren Buffett, Ray Dalio and the folks at American Funds that are getting all the above average returns.


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[mathjak107]

Some active investors just by chance will get above average some years. The knock on active is not than none of them ever do better than average. The knocks are:

1)MOST do worse than average or average at best and cost more doing it
2)None (practically) can consistently do better than average. A recent study showed 0.28% of funds remaining within the top 25% over the last 5 year period... http://www.spindices.com/documents/spiva/persistence-scorecard-june-2014.pdf
3)It is impossible to guess year to year which ones will do better- so given #1(above), the odds are you will pick wrong more often than right

Hence the smart money bets on Indexing...



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but as i say while most funds do not beat the indexes most active funds investors based on where they have their money do .

there are thousands of tiny funds that are at the top one year and the bottom the next and we rarely can even name them .

but if you look at the bulk of the funds where active investors have their money the results are very different.

funds like fidelity growth company , contra , low priced stock fund to name a few have tens of billions alone.

i think you will find that the old 80/20 rule may apply and 80% of investor money is centered in 20% of those middle of the pack good performers that usually beat the indexes over long periods of time even with their slightly higher fees.

i know my fidelity insight growth model is ahead by over 450k compared to had i bought a total market fund.


that is based on a 100k investment in 1987 when i started. they just use that middle of the pack group of plain old fidelity funds. rarely at the top but they just deliver good performance for the money.

 

[pb4uski]

Warren Buffet just bought a private placement partial stake into a company Axalta that is primarily owned by Carlyle Group, the group that coined the phrase. He has also partnered with 3G Capital, a private equity group, in buying shares in Heinz/Kraft Foods and the Tim Horton/Burger King deals. These are both companies of the type he has actually criticized as vultures looking for an exit strategy as soon as they purchase.

Most interestingly on the bet, which was actually only 320 thousand, which was the S&P500 would beat the Hedge Fund managers was each side would put the 320 thousand into a zero coupon bond that would then come to the million dollars at the end of ten years. The conservative "sure" zero coupon bond....

As far as I know 3G Capital doesn't divest. Probably why Buffet teamed up with them. They are still majority owner in Heinz, Kraft, Tim Horton, Burger King and AB/Inbev. So the vulture label doesn't apply. And from my own network I can tell these guys don't raid & dump. They do go in and shake things up seriously, like firing half or more of the senior management. They basically re-invented zero based budgeting as well. Buffet supplies capital, not management. 3G provides that.

Don't know the Axalta story, what I gather from the press release is that Buffet bought the shares from Carlyle shortly after an IPO. So it's not a partnership as with 3G, just a transaction where it's easier to buy directly vs. open market. He might disapprove of Carlyle (don't know), doesn't preclude dealing with them on favorable terms.....

+1 with Totoro

I'm not familiar with 3G Capital but we did consulting work with many private equity funds (including Carlyle) while I was working and none of the ones we worked with were "looking for an exit strategy as soon as they purchase". They generally look to hold at least 5-10 years and do exactly what Totoro described but if things turnaround faster and they can extract value sooner they will sell earlier.

Berkshire does do a lot of private placement financing where they can get good terms, just as Totoro describes.

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.

 

[NW-Bound]

If as a whole group, and over a long time, active investors get less than the market, then somebody else has their money. Indexers do not trade, so indexers do not get this money. Somebody else does.

Imagine a poker game. If you are not in the game, then you cannot win nor lose. So, we can leave the indexers out of the rest of this talk.

If you are in the game, an individual could either lose or win, but the pool of money is redistributed among this group of players. As a closed group, their wealth is constant. An individual can win one week, then lose even bigger the next. Still, the wealth among players remains constant, and is only shifted around.

If in this game, we observe that a player does poorly over time, then I have to conclude that another player must do well over time. That's what I meant earlier when I say that if somebody is below average, then someone else must be above.

So, back to the stats that we see all the time, which say active MFs as a group do not do well. Who has got their money? Correct me if I am wrong, but I think they only counted public mutual funds. I was thinking about the "other" active investors.

Namely, what about individual stock owners, hedge funds, pension funds, endownment funds, investment banks, sovereign funds, etc...? There are more active investors than just MFs. The above possible unseen players were whom I asked about in the earlier post, some of whom must have a better than 50% chance to buy low/sell high. Has their performance been compiled? Somebody'd better count up all the beans to see who's been collecting them. I am curious to know.

So, if it is true that most active investors trail the index, then a few smart ones among them get that money from the losers.

By the way, among public mutual funds, we cannot look at their price and say that its investors are winning or losing that much. Suppose fund A drops in price from $10/share down to $9/share. We cannot conclude that its investors have lost 10%. If we look at its assets, we may see that its assets drop more than 10%. That would mean that its investors have been bailing out along the way, and are not in for the full ride, hence lose less than 10% in the aggregate. Conversely, if fund A doubles in price, not all its investors get 100% richer, as some might just chase performance and just bought in yesterday.

PS. I see the post by gcgang that mentions some of the other "active investors". And mathjack also shows how looking at MF prices alone is not enough. One needs to look at the volume of the money flow. The conclusion is not as clear cut and simple as many studies and reports show.

 

[mathjak107]

any time a simple answer is given to complex issues that answer is usually wrong or flawed.

 

[ERD50]

...
If in this game, we observe that a player does poorly over time, then I have to conclude that another player must do well over time. That's what I meant earlier when I say that if somebody is below average, then someone else must be above.

So, back to the stats that we see all the time, which say active MFs as a group do not do well. Who has got their money? ....

I think Texas Proud answered this earlier - I'll try re-stating what he said:

Isn't it possible that the 'poor players' raise what you are calling the 'average' of the 'indexers'?

Imagine this scenario - a group of 100 people play games of chance for one night, and all put in the same amount and all split the 'house' gain/loss at the end of the night. Ninety-nine of them play 'fair' games, they all break even exactly, and the house has no gain/loss from these 99.

But one player chooses a high risk/high reward game that on average, has a statistical loss for the player. He loses that night, and the house gain gets split evenly among all 100 players. So 99 did above average, 1 did below. I think the problem with your description is that you are referring to the 99 as 'average', they are just common, but their 'average' is above average.

In a stock market, this means a poor active investor who buys high and sells low ends up selling to that larger group, and raising their average slightly.

That works, right? And I agree with others, it would not take very many active buyer/sellers to move the price of stocks held in the index. After all, only a portion of the outstanding shares are typically traded on any single day, yet the price of all those shares changes.

-ERD50

 

[NW-Bound]

By average, I mean average return. I do not mean the position in ranking, which is of course in debate.

I think we all agree that average return is the market return. No matter how many indexers are out there, if someone makes less than the market, than someone else makes more than the market. In the above post, I suggest we leave the indexers out of this.

In fact, if nobody indexes, and everybody trades, my argument still holds. If somebody keeps losing in a poker game, then someone keeps winning.

So, what I said is not in conflict with what Texas Proud wrote at all.

 

[NW-Bound]

It is very likely to be true that among all investors, indexers' ranking is better than 50%.

But that's the universe of all investors, and that includes a lot of small investors who clamored after dot-com stocks, lost money, and were not seen again for many years until the next bull market comes along.

PS. I just finished reading Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America. It describes how some illicit players even siphon off money from the market, and that lowers the average return for everybody. However, that's outside of the thread topic, as their activities involved more than pure trading.

 

[ERD50]

By average, I mean average return. I do not mean the position in ranking, which is of course in debate.

I think we all agree that average return is the market return. No matter how many indexers are out there, if someone makes less than the market, than someone else makes more than the market. In the above post, I suggest we leave the indexers out of this.

In fact, if nobody indexes, and everybody trades, my argument still holds. If somebody keeps losing in a poker game, then someone keeps winning.

So, what I said is not in conflict with what Texas Proud wrote at all.

Yes, we don't know who is getting the excess that the 'losers' give up. It could be the indexers, it could be the active winners?

So that has me thinking, we often see that the majority of active funds trail the index, but what is their average? Maybe a few of the active winners win by a large amount, and the average could be positive (or slight either way)?

-ERD50

 

[NW-Bound]

Yes, we don't know who is getting the excess that the 'losers' give up. It could be the indexers, it could be the active winners?

So that has me thinking, we often see that the majority of active funds trail the index, but what is their average? Maybe a few of the active winners win by a large amount, and the average could be positive (or slight either way)?

-ERD50

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?

 

[meierlde]

Yes, we don't know who is getting the excess that the 'losers' give up. It could be the indexers, it could be the active winners?

So that has me thinking, we often see that the majority of active funds trail the index, but what is their average? Maybe a few of the active winners win by a large amount, and the average could be positive (or slight either way)?

-ERD50

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.