Index funds make the market more volatile??

[Chuckanut]

Here's some food for thought, or propaganda from those who sell managed funds?

As I read the article it seems to be saying that index funds cause the entire market to walk in lock-step so that the market will tend to move up and down in bigger steps than it normally would. Also, Index funds also eliminate investors thinking and acting individually. We all buy and sell the same basket of stocks, rather than a variety of different stocks depending upon our investment beliefs.

The Intelligent Investor: Are Index Funds Messing Up the Markets? - WSJ.com

[RetireBy90]

Hehehe I read this also. I was left wondering about him. If index funds don't chase the market or stocks, it would seem to dampen volitity. The theory was investors jumping in and out of funds, which then would have to buy or sell. How index funds would be any different than active managed funds I don't understand.

I do see his point that as index funds get more of the market, they would tend to cause the market to move in step, good companies and bad. I am still thinking how to react, could I buy good stocks cheaper, or does this just make crappy stocks trade closer to the market?

[easysurfer]

Quote:

Originally Posted by Chuckanut ... Also, Index funds also eliminate investors thinking and acting individually...

That's one of the major benifits of index funds. To protect from thinking and acting too much .

[sengsational]

It would seem to me that all the hedging and arbitrage is where the volitility comes from. They may be able to play off of the predictability that comes from so much volume in index funds.

[unclemick]

Quote:

Originally Posted by easysurfer That's one of the major benifits of index funds. To protect from thinking and acting too much .

heh heh heh - 18 yrs of ER and counting. All praise to Saint Jack.

[easysurfer]

Quote:

Originally Posted by unclemick heh heh heh - 18 yrs of ER and counting. All praise to Saint Jack.

Put another way, index funds is like getting a passing grade in school and not having to study

You think maybe the person who wrote that article suffers a bit of sour grapes against index funds?

[RetireBy90]

Doesn't it make you wonder where the thought full examination is supposed to come from? Aren't individual investors who can look for long term investments supposed to be able to out perform the pro who has to beat each quarter?

[RockyMtn]

I don't know that I necessarily would lay the problem of market volatility at the feet of index funds. It would seem that funds that track a large basket of stocks would be just the opposite because of the depth of the holdlings. In addition it doesn't seem to me that we have had any wild levels of volatility. So far this year the market seems to be acting relatively rationale to me....a slow melt up. No big wild swings.

I would think that excessive program trading and the so called "quants" logarithm trades are the real cause of excess vloatility.

[Ed_The_Gypsy]

Annual turnover in index funds is very low. Turnover in managed funds can be 300% to 400%. Programmed trading created the crash of '87.

[Chuckanut]

Pesonally, I find it interesting that low-cost index funds are taking this heat, while it is still possible to sell short on a down tick, and Glass-Stegall is still history. Remember the flash-crash a while back. I doubt if index funds caused that.

[DFW_M5]

I could see how index ETFs might lead to more volatility vs a mutual fund index due to ease of trading in or out at defined price.

[okapi]

The number of people who invest in index funds has recently shot up to 235.Wall St. hates index funds.So lets parade out anything bad we can muster up about them.Ignore Wall St. noise.They have their best interest at heart,not yours.

[clifp]

I think the WSJ article and this thread is somewhat misrepresenting Professor Wurgler paper.

Index funds aren't causing increase volatility except indirectly in that traders have more derivative products to use.

The problems are related to that increased correlation among different asset classes in general and among the S&P500 stocks in particular. Stock prices move in a more herd like fashion now than the have in the past. This makes it harder for investors to achieve a diversified portfolio. There is hardly much of a point to having small cap, large cap, growth, value, international stocks/fund etc. when the all move the same direction all the time.

The second point is particular to the S&P 500, the paper discusses the premium that occurs when a stock gets included in the S&P500 (20-25 changes are made per year).
His data showed that the stocks in included in the S&P500 may get as much 30% price premium simply by being included in the index. Stocks jump immediately when are included by 5-10% and fall as much as 10-20% when the drop out of the S&P and overtime this over performance continuing. Considering that up until two years ago, a big companies such as Buffett's Berkshire weren't in the S&P there are some problems with the index. But the bigger problem is that as whole the S&P500 has (according the Wurgler) accounts for 78% of the market cap of the US stock market if that is overvalued by 30% we should probably be seeing the S&P only account for 60%. This mean that capital costs for the ~10,000 (generally smaller) companies not in the index are paying too much for capital.

One of the dangers I see is that we are letting Standards and Poor pick the winners and losers by who the included in the index, and given their crappy track record in everything from evaluating mortgage backed securities to municipal bonds I am not thrilled about them taking the place of a real market.

Quote:

"Markets work best when people think and act independently, not all together",Mr. Sullivan says

This is probably the most subtle argument in the paper. If we assume that valuing stock is actually a skill, and people other than Warren Buffett, are good at it that we need to let them be successful. The only way indexers can enjoy a free ride is because there are active investor who figure out which companies are the next Enron, Citi, Kodak, and the next Google, Apple, Walmart. If the herd mentality of index funds become more dominate, then there is a risk that good and bad manager/companies are treated pretty much the same way, sincenot enough people are acting independently.

Wurgler view is that because of the rise of indexing it is increasingly difficult for active manager to differentiate themselves it is worth reading the paper to understand why.

The argument against indexing is similar to the paradox of thrift. As individuals it is great that we save, but during a recession if everybody saves then overall demand goes down making the economy worse. We have seen this during this recession and increase government spending has not been able to counter act the impact of increased saving.

The same thing is true for indexing. It is great for individual to use indexes, but if everybody switches to an index funds than we are collectively screwed.

[gerntz]

"One of the dangers I see is that we are letting Standards and Poor pick the winners and losers by who the included in the index, and given their crappy track record in everything from evaluating mortgage backed securities to municipal bonds I am not thrilled about them taking the place of a real market."

My understaning is that S&P aren't "picking" what stocks to be in their 500. Rather they have set criteria companies need to meet; i.e., the companies pick themselves.

[clifp]

Quote:

Originally Posted by gerntz "One of the dangers I see is that we are letting Standards and Poor pick the winners and losers by who the included in the index, and given their crappy track record in everything from evaluating mortgage backed securities to municipal bonds I am not thrilled about them taking the place of a real market." My understaning is that S&P aren't "picking" what stocks to be in their 500. Rather they have set criteria companies need to meet; i.e., the companies pick themselves.

That is not what how I read the criteria Standard & Poor has outlined in this document.

Quote:

One of the most frequent questions we get at Standard & Poor’s is, “What are the criteria for being added to an S&P Index?” First and foremost, S&P Indices are not rules-based; all changes are fully discretionary and are determined by the Index Committee based upon public information. Companies may not apply for inclusion. The Standard & Poor’s Index Committee examines five main criteria when looking for Index candidates: trading analysis, liquidity, ownership, fundamental analysis, market capitalization, and sector representation. Explaining these five items may give investors a better understanding of the Index management process

Ultimately it is beauty contest and the committee are the judges. Much like the Miss America contest they do have a set of criteria, and weigh things like market cap, profitability, and the all important industry leadership. But there plenty of times that S&P companies are no longer industry leaders nor among the top 500 in Market Cap. Berkshire Hathaway is classic example currently ranked #7 on the Fortune 500 list was not included in the S&P until 2010, because the B share were trading around $4,000 and trading volumes were deemed to low by the esteemed S&P index committee. Berkshire owners aren't typically day traders.

Now imagine we were trying to determine the most beautiful girls in the USA and were conducting a nationwide election. Obviously the Miss America winner and finalist would be among the contenders. However, if 30% of population decided it was too difficult to figure out the most beautiful girls (ya I know really really far fetched especially for us guys) and instead of looking at the pictures cast the votes the same way as the Miss America judges. How hard would be for a non Miss America contestant to win the competition? How confident would you be that the winners of contest was truly the hottest girl in the land?

[HFWR]

Index ETFs might very well increase trading frequency, especially among retail-style investors. But I would distinguish between investors and "traders", I.e. those trying to squeeze a nanocent out of the spread by rabid rapid program trading.

[DFW_M5]

Quote:

Originally Posted by HFWR Index ETFs might very well increase trading frequency, especially among retail-style investors. But I would distinguish between investors and "traders", I.e. those trying to squeeze a nanocent out of the spread by rabid rapid program trading.

I like the rabid term better and by the way, does HF stand for high frequency

[HFWR]

Quote:

Originally Posted by DFW_M5 I like the rabid term better and by the way, does HF stand for high frequency

Close. It's "high frequently"...