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What happens when everyone is using index funds?
Old 04-08-2015, 12:46 PM   #1
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What happens when everyone is using index funds?

I've been thinking lately, what happens when everyone is using index funds. All the "wisdom" I've read from those with more experience, it seems that a rule is that once a rule is accepted by all it doesn't work any more. Just trying to think this through.

If say Northern Widget Co and Southern Widget inc both in the same business and with the same sales and profits, say both sell for $10/share.

Now lets further say Southern Widget inc gets into a new line of business and they double earnings per share and Northern Widget Co doesn't change, then one share of Southern should be worth $20 and Northern would still be worth $10. However, index funds don't buy and sell based on earnings, they hold the entire market. Who is left to push up Southern closer to share price of $20 ?

Does this not mean that as index funds gather a greater portion of investments, potential rewards are even greater for those willing to buy based on earnings or other valuation metrics? If shares of Southern say go to say $15 that would mean a greater value than Northern at $10. Right ?

I'm currently using index funds where I can (my 401K doesn't have index funds for many categories) with a small portion in individual stocks so I'm a believer in index funds, but if we keep going with greater and greater portion of investments going to index funds, I'm trying to be open minded about the selection of index funds at some point. It may end up being a generation away or more. My parents grew up when mutual funds were just becoming popular and all had sales charges. Then we got no load funds, and now we have index funds. Each of these were great at the time they came out, but have been supplanted by the next.

Just thinking out here - anyone else have similar discussions with your self?
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Old 04-08-2015, 12:51 PM   #2
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Jim Cramer has made that point- that by careful stock selection you can do better than just buying the index or the ETF for a sector of the market.


I've got a big mix of investments- probably more complicated than it needs to be- and am gradually shifting to Index funds and ETFs. I'm watching my individual stocks, though, and they're outperforming the indices. I don't think I'll ever get out of individual stocks but I'm getting less tolerant of mutual funds that pretty much track the relevant indices.
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Old 04-08-2015, 12:54 PM   #3
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Who is left to push up Southern closer to share price of $20 ?
you will still have investors buying and selling individual stocks (consider large pension fund managers, for example) - that would be an arbitrage opportunity that would quickly correct itself
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Old 04-08-2015, 12:55 PM   #4
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Jim Cramer has made that point- that by careful stock selection you can do better than just buying the index or the ETF for a sector of the market.

every time I'm in the gym and he's squawking on TV I wonder how much money he's lost in the market - if he was so good at picking stocks he wouldn't be on TV


wasn't he the one that was publically touting beat sterns as a strong buy then they went under two days later?


looks like he has zero credentials - he's just a journalist - http://www.nerdwallet.com/blog/inves...ad-money-host/
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Old 04-08-2015, 12:58 PM   #5
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Just thinking out here - anyone else have similar discussions with your self?
Research Affiliates has done lots of research looking at building indices based on other valuation methods instead of revenue. RAFI Fundamental Index
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Old 04-08-2015, 01:57 PM   #6
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It will NEVER happen...

First, there are a lot of people who just do not know what to do and listen to a FA.... they do not put people in index funds (much)...

Second, there are always going to be people who think they are smarter than the market.... they will either invest in managed funds or individual stocks....

Third, there will always be people/companies that are looking for the trade arbitrage... think day traders... if they see that a stock should be $20 and is priced at $10... they will buy it up...
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Old 04-08-2015, 01:59 PM   #7
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Old 04-08-2015, 02:09 PM   #8
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Originally Posted by Texas Proud View Post
It will NEVER happen...

First, there are a lot of people who just do not know what to do and listen to a FA.... they do not put people in index funds (much)...

Second, there are always going to be people who think they are smarter than the market.... they will either invest in managed funds or individual stocks....

Third, there will always be people/companies that are looking for the trade arbitrage... think day traders... if they see that a stock should be $20 and is priced at $10... they will buy it up...
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Old 04-08-2015, 02:49 PM   #9
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All we need is a trader or two to set "fair" prices for stocks. Or switch back to actively managed funds. Not a big deal.
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Old 04-08-2015, 03:06 PM   #10
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Quote:
Originally Posted by Texas Proud View Post
It will NEVER happen...

First, there are a lot of people who just do not know what to do and listen to a FA.... they do not put people in index funds (much)...

Second, there are always going to be people who think they are smarter than the market.... they will either invest in managed funds or individual stocks....

Third, there will always be people/companies that are looking for the trade arbitrage... think day traders... if they see that a stock should be $20 and is priced at $10... they will buy it up...
+2

The new CEO of Fidelity believes this as well

WSJ article on Fidelity
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Old 04-08-2015, 03:14 PM   #11
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Quote:
Originally Posted by Texas Proud View Post
It will NEVER happen...

First, there are a lot of people who just do not know what to do and listen to a FA.... they do not put people in index funds (much)...

Second, there are always going to be people who think they are smarter than the market.... they will either invest in managed funds or individual stocks....

Third, there will always be people/companies that are looking for the trade arbitrage... think day traders... if they see that a stock should be $20 and is priced at $10... they will buy it up...
Plus, there is an incredibly powerful and wealthy industry based on convincing people to do the exact opposite of what the OP suggests. I don't think enough people could be convinced to go with indexing to overcome the impressive advertising campaigns that tell them to "trust us (FAs)". Just not going to happen.
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Old 04-08-2015, 03:17 PM   #12
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+2

The new CEO of Fidelity believes this as well

WSJ article on Fidelity
People will always find a way to market their skill at beating the market. They are not timing the market or stock picking they are using "smart beta" or it will be some other clever arbitrage tool. Problem is as always, everyone is using "smart beta" or whatever tool against each other, so we are back to indexing.

We will never run out of people trying to beat the market or thinking that those that just settle for market returns as fools.
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Old 04-08-2015, 03:21 PM   #13
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We will never run out of people trying to beat the market or thinking that those that just settle for market returns as fools.
Yes indeed, many people hate being thought of as "Mr Average" and are sure they can do better.
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Old 04-08-2015, 03:38 PM   #14
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What happens when every investor is indexing? The same thing when everybody becomes Democrat, or Republican, or Communist.

We will all retire early, drive off into the sunset in our RV, and when we die, we will all go to heaven.

Seriously, it is funny how indexers like to pick on active stock pickers, while at the same time relying on the latter to decide that a company making cancer wonder drugs, or superb lithium batteries should be worth more than the one making buggy whips. It is so that when a young company becomes successful, they will add it to their index.
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Old 04-08-2015, 04:09 PM   #15
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There are more variations of stock fund groupings, than there are stocks themselves. They will slice and dice until 100 versions of every conceivable idea is possible, even a fund of stocks that are not in any funds.

No effect, except fees are now annual versus transactional. Is that better?


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Old 04-08-2015, 04:11 PM   #16
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We will never run out of people trying to beat the market or thinking that those that just settle for market returns as fools.
And I thank goodness for them every day. These people keep the market efficient, and they assure indexing continues to work. I'm a free rider on the dues they pay.

Anyway, this is a subject that has been looked at a lot, and we're in no danger of approaching a time when index investors dominate equity pricing. IIRC, index funds/ETFs account for only about 15% of the equities in the market.
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Old 04-08-2015, 05:40 PM   #17
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If everyone invested in indexes, everyone would get the true market value (growth and dividends of the underlying companies). Isn't that the whole point in the first place?
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Old 04-08-2015, 05:52 PM   #18
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Let's reread what the OP wrote.

Quote:
Originally Posted by RetireBy90 View Post
If say Northern Widget Co and Southern Widget inc both in the same business and with the same sales and profits, say both sell for $10/share.

Now lets further say Southern Widget inc gets into a new line of business and they double earnings per share and Northern Widget Co doesn't change, then one share of Southern should be worth $20 and Northern would still be worth $10. However, index funds don't buy and sell based on earnings, they hold the entire market. Who is left to push up Southern closer to share price of $20 ?
Without active investors, indexers buy and sell every component company in a fixed proportion (until the index committee decides to add or to throw out a company).

There is no reward, i.e. price appreciation, for a company doing well vs. a company doing poorly, if it weren't for the active stock owners who set the individual stock prices via market action.
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Old 04-08-2015, 07:04 PM   #19
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If everyone invested in indexes, everyone would get the true market value (growth and dividends of the underlying companies).
By making buy/sell decisions using all known factors about each company and each stock, it is the active investors that establish true market value. Index investors don't help with that. We just take advantage of it.
In theory, if there are too many index investors, they would distort the pricing signals and soon many stocks would be selling for more or less than they would be objectively worth. Luckily, at that point the payoff for ective investing would be really good and more people would start doing it again.

Any system that effectively harnesses individual greed ambition for the public good is a wonderful thing.
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Old 04-08-2015, 07:13 PM   #20
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Yes indeed, many people hate being thought of as "Mr Average" and are sure they can do better.
I guess then that it is a fascinating paradox that index investors who are allegedly settling for average more often than not end up with above average performance. How does that happen?
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