I believe in indexing. Bogle has made his case, the results are there, and it's what I do (in general).
But, I've come to think that while indexing would always work as intended in a perfect world (free markets, lots of transparency and legit bookkeeping, etc), in our real world things are different.
From a recent Bloomberg article on China's Shenzhen market craziness:
It's not just a typical investor mania, valuations are being driven by Chinese government manipulation and market distortions (those young Chinese with money to invest for the first time can't choose US stocks or other options--the money is captive in China, which drives equity prices up even before foreigners dump money in). It would seem that such a market might be one that US index funds would avoid. Indexing's underlying assumption ("I can trust the prices, because both buyers and sellers are free to seek other options") isn't valid. And this is just an example of a much wider problem. Another one: Bonds given special status (and pricing power) by the US government because of their ratings.--ratings granted by selected "approved" ratings agencies--that were apparently influenced by the payments they received from those they rated. I own bond indexes, so I overpaid for those crummy bonds (as did active managers--but at least they were supposed to be discerning and could choose to buy better ones). When Greece's troubles were clear but their bonds hadn't been officially downgraded, some European govt bond indexes were loading up on Greek bonds as though they were German (hey, Greece is in the Eurozone, these are government bonds, we're just buying what's in the index . . ).
If the index is cap weighted (like almost all are), then you'll be buying more and more of the insanely over-bought stocks as the investor mania continues. Maybe we need a "past 12 months earnings" weighted index. But wait, that's no guarantee of avoiding the madness: Value investors were heavily invested in financial companies in 2008 (their earnings were good--because of a different bubble-inducing government distortion). So, earnings aren't a sure measure of value, since the earnings can be based on distortions.
I remain an indexer, a true believer. But as the markets froth up, I am starting to feel a bit like a Christian Scientist with appendicitis.* I'm looking a little closer at how these indexes are constructed, and am not jumping into any hot new index funds just because they are offered by a big fund company. I'm recognizing that some sectors may not be appropriate for indexing, and probably not even for my investments in any form. And I'm starting to think that, just maybe, the hard, cold, cynical judgement of a mature value-oriented stock picking curmudgeon can be worth something.
Just some thoughts on a rainy morning.
*Apologies to Tom Lehrer
But, I've come to think that while indexing would always work as intended in a perfect world (free markets, lots of transparency and legit bookkeeping, etc), in our real world things are different.
From a recent Bloomberg article on China's Shenzhen market craziness:
Great news, indexers! Vanguard has announced that these stocks will soon be in Vanguard's Emerging Market Index Fund. Get 'em while they are hot!The Shenzhen market is up almost 200 percent over the past year. Its price-earnings ratio stands at a little less than 80. (Standard & Poor's 500 Index is up 9 percent and has a ratio of 19.) Much of the demand for Chinese shares is credit-fuelled and comes from small investors new to the game. In one week in April, according to The Economist, Chinese investors opened 4 million new brokerage accounts -- and, by the way, two-thirds of the country's newcomers to investing left school before the age of 15.
Technology stocks, heavily represented in the Shenzhen index, are especially in demand. (Tech stocks: What could possibly go wrong?) The price of China's highest-flying stock, Beijing Baofeng Technology Co., increased 4,200 percent in the 55 trading days after it went public; on Friday it was valued at 715 times reported earnings.
It's not just a typical investor mania, valuations are being driven by Chinese government manipulation and market distortions (those young Chinese with money to invest for the first time can't choose US stocks or other options--the money is captive in China, which drives equity prices up even before foreigners dump money in). It would seem that such a market might be one that US index funds would avoid. Indexing's underlying assumption ("I can trust the prices, because both buyers and sellers are free to seek other options") isn't valid. And this is just an example of a much wider problem. Another one: Bonds given special status (and pricing power) by the US government because of their ratings.--ratings granted by selected "approved" ratings agencies--that were apparently influenced by the payments they received from those they rated. I own bond indexes, so I overpaid for those crummy bonds (as did active managers--but at least they were supposed to be discerning and could choose to buy better ones). When Greece's troubles were clear but their bonds hadn't been officially downgraded, some European govt bond indexes were loading up on Greek bonds as though they were German (hey, Greece is in the Eurozone, these are government bonds, we're just buying what's in the index . . ).
If the index is cap weighted (like almost all are), then you'll be buying more and more of the insanely over-bought stocks as the investor mania continues. Maybe we need a "past 12 months earnings" weighted index. But wait, that's no guarantee of avoiding the madness: Value investors were heavily invested in financial companies in 2008 (their earnings were good--because of a different bubble-inducing government distortion). So, earnings aren't a sure measure of value, since the earnings can be based on distortions.
I remain an indexer, a true believer. But as the markets froth up, I am starting to feel a bit like a Christian Scientist with appendicitis.* I'm looking a little closer at how these indexes are constructed, and am not jumping into any hot new index funds just because they are offered by a big fund company. I'm recognizing that some sectors may not be appropriate for indexing, and probably not even for my investments in any form. And I'm starting to think that, just maybe, the hard, cold, cynical judgement of a mature value-oriented stock picking curmudgeon can be worth something.
Just some thoughts on a rainy morning.
*Apologies to Tom Lehrer
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