Dangers of indexing?

[Gone4Good]

'Cause then you wouldn't have a Legg to stand on.

 

[ERD50]

That was one thing that always bothered me about indexing. Another was that stocks that go into the S&P500 are handpicked by a committee - AFTER they have already shown themselves to be "hot", and get dropped after they show themselves to no longer be "hot" for a long while.

But the final thing that turned me off to indexes like the S&P500, is the market-cap weighting. You end up with such distortions in terms of diversification.

The much broader indices make more sense to me.

Audrey

I agree that those are concerns, but the broader indexes are also cap weighted (I think?). And are those distortions significant? Are the offset by the need to buy so many more stocks - the smaller ones may carry wider spreads?

-ERD50

 

[audreyh1]

I agree that those are concerns, but the broader indexes are also cap weighted (I think?). And are those distortions significant? Are the offset by the need to buy so many more stocks - the smaller ones may carry wider spreads?

-ERD50

Yeah, I still don't like the cap-weighting approach.

 

[Gone4Good]

Yeah, I still don't like the cap-weighting approach.

There are fundamentally weighted indexes now available.

But here's my thought process on those. If the market actually does a good job of valuing securities, then cap-weighting is the way to go. If, however, it misprices stocks significantly, than a fundamentally weighted index would be better. But if that were the case, active managers should be able to exploit those mispricings better than the simple screens used in fundamentally weighted indexes. But active managers generally underperform cap-weighted indexes. So maybe the market actually does a good job of valuing securities, in which case, we're back to the plain old regular indexes.

 

[ERD50]

Yeah, I still don't like the cap-weighting approach.

I agree that it just feels 'wrong' in terms of diversification, a large portion of the value is really in those top few stocks, but...

There are fundamentally weighted indexes now available.

I was under the impression that cap-weighted was the only 'efficient' way to do an index. With cap weighting, they don't need to adjust any holdings if say, the #1 stock doubled or halved in price, because its cap doubled or halved also. So it stays in balance, it's consistent and does not take tweaking.

Maybe a fundamentally weighted index allows a wider range to reduce buy/sell churning? I dunno?

-ERD50

 

[LOL!]

Some stock pickers have complained that the stocks they select do not behave as expected because the stocks are in the index. For instance, a bad stock should be going down, but since the index fund holding it is going up, it goes up as well as index managers have to buy it.

 

[Gone4Good]

I was under the impression that cap-weighted was the only 'efficient' way to do an index.

Yup.

It's funny how fixing one disputable problem with traditional indexing necessarily means incurring an indisputable one.

 

[Gone4Good]

Some stock pickers have complained that the stocks they select do not behave as expected because the stocks are in the index. For instance, a bad stock should be going down, but since the index fund holding it is going up, it goes up as well as index managers have to buy it.

It's pretty common among stock pickers to explain how they got the valuation right but they somehow still lost money because other people are stupid.

 

[audreyh1]

There are fundamentally weighted indexes now available.

But here's my thought process on those. If the market actually does a good job of valuing securities, then cap-weighting is the way to go. If, however, it misprices stocks significantly, than a fundamentally weighted index would be better. But if that were the case, active managers should be able to exploit those mispricings better than the simple screens used in fundamentally weighted indexes. But active managers generally underperform cap-weighted indexes. So maybe the market actually does a good job of valuing securities, in which case, we're back to the plain old regular indexes.

Yeah, I guess I don't believe the market does that good a job valuing securities and significant mispricings occur in the short-term. But that does not mean that active managers can easily exploit them either. I've found that my AA approach does a pretty good job of exploiting temporary mispricing and I just have to play the active manager in one asset class off against another.

Audrey