Is indexing good?

[greg]

I received this article as an e-mail and thought it relevant, especially to those FIREing. I suspect this issue has come up before on this board, but a revisit may be worth it. It gives the best argument against indexing I've seen. You need to click the "next" button in left hand corner at the bottom of each page to see the entire article:

http://www.investorsinsight.com/otb_va.aspx?EditionID=233

--Greg

 

[Nords]

It gives the best argument against indexing I've seen.

Great article, but once again they forgot to include the names of the managers who are going to generate positive alpha over the next couple decades. When the odds are stacked 80/20 against the average (blissfully ignorant) investor, I can understand why so many of them run to Gus Sauter. And for those of us who aren't interested in searching out talented management at any cost, there are ETFs.

Does John Mauldin ever write his own columns anymore? Don't get me wrong, I'm impressed by a guy who appears to have a true talent for getting other people to do his work for him, but he sure has a lot of "guest" columnists.

 

[justin]

"The only way to get "alpha" is to be willing to invest without looking over your shoulder at some index. "

In other words, in order to beat the market, just ignore it?

 

[ladelfina]

From a completely non-investment-guru point of view, this phrase struck me..

indexers might keep outperforming but the long term returns of the stock markets will fall, as a sign that the economy's structural growth rate is falling.

So what's the incentive for any one index investor to quit index investing.. altruism? Single-handedly volunteering to prop up the economy?  

 

[grumpy]

Maybe I am not thinking about this correctly but I don't get the "misallocation of capital" claim. For the companies included in most of the major indices, when I buy a share of their stock there is NO effect on the company's capital. With the exception an IPO or secondary offering, the share I buy is being sold by another investor, not the company. The same is true when an index mutual fund buys shares of a company in the index. So how does indexing result in misallocation of capital?

Grumpy

 

[justin]

Maybe I am not thinking about this correctly but I don't get the "misallocation of capital" claim. For the companies included in most of the major indices, when I buy a share of their stock there is NO effect on the company's capital. With the exception an IPO or secondary offering, the share I buy is being sold by another investor, not the company. The same is true when an index mutual fund buys shares of a company in the index. So how does indexing result in misallocation of capital?

I only skimmed the article, but I gleaned it was "misallocation of capital" because investors put money into something because it is a member of an index (or, "just because"). The author's version of appropriate allocation of capital is apparently based on the underlying performance and fundamentals of the companies - good companies with good growth prospects (and/or good values with low P/E's, P/B's or whatever). Grumpy, what you said is true - it isn't an issue of allocation of capital between investors and the target of the investment (publicly traded companies), only between the universe of investors.

 

[SteveR]

The following is my own personal opinion and like @ssholes, everyone has one, so take it for what its worth.  

The lack of data in this article along with the convoluted discussion and the lack of a fact-based conclusion, convinces me that the author has a vested interest in moving money from index funds to hedge funds.  It would appear that perhaps there could be a financial incentive for the author to convince investors to forgo index funds and move to investing in higher expense funds.  The winner is the hedge fund manager and the loser is the investor by paying more in fund expenses while taking on more potential risk.  

In short....scare the index fund investor out of these low expense (low profit) funds and into higher expense (higher profit) funds.  The fund managers will get rich on the backs of the investors.  

Then again.....I could just be paranoid.  

 

[Jay_Gatsby]

The following is my own personal opinion and like @ssholes, everyone has one, so take it for what its worth.  

I think the rest of the joke is that nobody thinks theirs stings.

And no, you're not paranoid. The vast majority of financial literature is slanted one way or another. People don't write articles for their health -- they write articles to make money -- whether through telling people what they want to hear, and thereby selling more newspapers/magazines, or by convincing them that they need to take action and the author's the answer!

 

[ats5g]

1) the "fact" that indexing or investments in indexfunds caused the late 1990's bubble is pretty laughable. Where's the evidence? There isn't any. Plus there were bubbles way before index funds.

2) And it didn't start out with index funds buying stocks that were overvalued and then active managers/investors started piling in. Since index funds just buy the stocks that are reflected by the active managers/investors , it must've been the active managers/investors starting the bubble.

I wonder how much these guys are getting paid by the hedge funds? 

- Alec

 

[justin]

I think the rest of the joke is that nobody thinks theirs stings.

Prep-H can cure those stings.

 

[greg]

Maybe I am not thinking about this correctly but I don't get the "misallocation of capital" claim. For the companies included in most of the major indices, when I buy a share of their stock there is NO effect on the company's capital. With the exception an IPO or secondary offering, the share I buy is being sold by another investor, not the company. The same is true when an index mutual fund buys shares of a company in the index. So how does indexing result in misallocation of capital?

Grumpy

Grumpy:

I really need to reread the article before responding completely, but . . . It's a misallocation of 'your' capital in that you are not buying the best possible companies out there. Rather you are buying into an index fund that that has its own seperate criteria for entry, does GE belong to the S&P 500? for instance. It doesn't mean, for example, that GE is misallotating any new capital it is receiving (that's a different issue). It means that you are just adding your capital not to GE but to the pool held by other shareholders of GE, irregardless of its fitness to be a growing, dynamic company. You end up buying into GE because it is part of an index instead of buying into GE because it's a great company. That's part of the macro-misallocation. All the companies in the S&P500 grew not necessarily just because they grew earnings but because their share price went up due to people buying that index fund. The index may end up bubble-like because lots of people and pensions stuff money into them because they have been told this is the best way to allocate retirement resources. A self-fulfilling tautology in a sense.

And it's worked very well for the past twenty some years until everybody starts doing it (then you can have serious macro problems)or when everyone starts pulling out (using their retirement monies. also, remember the demographic shift thas is now coming?) over the next twenty years, which is one type of macro problem. Bogle is not necessarily correct forever, but he sure had a heck of a run.

 

[Mr._johngalt]

Then again.....I could just be paranoid.  

Yep!

JG

 

[Nords]

The lack of data in this article along with the convoluted discussion and the lack of a fact-based conclusion, convinces me that the author has a vested interest in moving money from index funds to hedge funds.  It would appear that perhaps there could be a financial incentive for the author to convince investors to forgo index funds and move to investing in higher expense funds.

Well, he IS a money manager.  Apparently he also needs to distribute newsletters & sell his books, which is why he must be too busy to write his own articles.

But how could not trust a guy with the guts to wear a tie like this?

 

[grumpy]

I can see that there is an element of positive feedback where index funds are concerned. If a company has a large market cap, then managers of index funds have to buy alot of its shares. But remember, in order to buy shares, someone must sell the shares. The ultimate price of the shares is still determined by the balance of buyers and sellers. If the company has a large market cap, but is a poorly run enterprise, there should be more sellers than buyers, so the price should drop. It is only if the vast majority of the shares of a company are already owned by index funds that the positive feedback loop will drive the share price in an upward spiral. I don't have the data but I suspect that the percentage of any large company's shares owned by index funds is not large enough for this to be a significant problem.

Grumpy

 

[BigMoneyJim]

The index may end up bubble-like because lots of people and pensions stuff money into them because they have been told this is the best way to allocate retirement resources.

I've worried about this a couple of times before, but I decided there are still way more non-indexers than indexers and it's not going to be a problem soon. I like to think this board's membership is a big fan of indexing, but a lot of posters are slice-and-dicers and allocation shifters. A surprising number of posters show high-fee managed funds when they post their allocations, although many such posts are new posters or regulars who bought into something not cheaply escaped from. I don't talk to many people about finance, but those that do seem to have an uneasy feeling about a computer managing their investment and get warm fuzzies thinking some highly paid expert is at the helm.

Anecdotal evidence to be sure, but I'm happy with it so far. Also, arguably I'm not an indexer anymore as I'm heavy into Wellington, have a slice of REIT index and am in LifeStrategy Moderate Growth which has a managed component (Asset Allocation Fund). I consider myself an indexer at heart, though; I chose Wellington and LS for their index-likeness and built-in rebalancing.

 

[greg]

I can see that there is an element of positive feedback where index funds are concerned. If a company has a large market cap, then managers of index funds have to buy alot of its shares. But remember, in order to buy shares, someone must sell the shares. The ultimate price of the shares is still determined by the balance of buyers and sellers. If the company has a large market cap, but is a poorly run enterprise, there should be more sellers than buyers, so the price should drop. It is only if the vast majority of the shares of a company are already owned by index funds that the positive feedback loop will drive the share price in an upward spiral. I don't have the data but I suspect that the percentage of any large company's shares owned by index funds is not large enough for this to be a significant problem.

Grumpy

Grumpy:

http://finance.yahoo.com/q/mh?s=GE

I suspect even the institutional holders are 'holding in trust' for retirement funds. The percentage could even be much higher. John Mauldin in his previous book, Bullseye Investing, spent a fair portion of it talking about the demographic problems of the baby boomer generation and how it may affect their retirements. We face similar problems w/ Social Security because the lockbox contains gov't bonds that only healthy taxes can pay off.

Another sort of strange fluke about the S&P 500 indexes is that before stocks get into it they have already grown substantially: Somebody else usually catches all that serious growth and index buyers sort of get some after that inclusion. When was the best time to buy Microsoft? If large-cap stock indexing is your only form of investment appreciation (I know, nobody does this) then you may be taking unneccesary risk for a limited exposure to gains.

I think there will be a fairly strong element of positive feedback in the GE statistics.

Thanks for the question. I enjoy thinking worrying about it.

 

[greg]

BMJ: I am not trying to say "don't" even thought it sounds like it sometimes. All I'm trying to do is explain the risks as I see them. Everybody is ultimately responsible for there own money. I don't even think index funds shouldn't be in a portfolio. One just needs to know how and why they act the way they do--so that one doesn't end up doing excessive amounts of timing selling near the bottom of a big market drop and not buying back in on the way up because of fear. To me a diverse and solid portfolio does what is expected when the things that may happen do happen. This takes some thinking and work. Sometimes it means living on dividends and interest until the price returns to a normal range. Nobody can do this better than the individuals owning the portfolio--or they need to learn it. To me, FI in FIRE means what it says.

 

[Gone4Good]

But remember, in order to buy shares, someone must sell the shares. 

Yes, bought shares must equal sold shares but the price of the exchange is not necessarily at the pre-exchange price.  If someone wants to buy 1MM shares at the current market price of $50, he may be only able to buy 500K at that price, and the remaining 500K is only available at $51 - meaning that his purchase affects the market clearing price.  If, in this example, the purchase is the result of an arbitrary investment rule (like an index fund) then the $1 appreciation in stock price, and the resulting lower cost of capital for the firm, may be construed as a misallocation of capital because one side of the exchange is acting irrationally or arbitrarilly.  (A rational seller will naturally offer to sell his shares at a premium to 'fair market value')

However, this misallocation of capital will persist only in an inefficient market.  It is therefore true that John Mauldin's argument can be summarized as simply saying "capital markets are not efficient and investors can exploit these inefficiencies to outperform the market." (ignoring the follow-on conclusion that investor's attempts to exploit these inefficiencies causes the market to become more efficient)  In Mauldin's version, it is the prevalence of indexing (both overt and covert) that causes the market's inefficiency - but whatever the cause, his argument is essentially no different than that of anyone else who advocates active investment management.   

 

[justin]

Apocalypse,

I failed to see your point re: GE being owned in large quantities by index funds. The "Major Holders" listing you linked to at Yahoo Finance showed that of the top ten mutual fund holders, only 3 were index funds. That means 7 actively managed funds are making big bets on GE. Are you saying that a minority position (that which is owned by index funds) is causing huge distorting effects and inefficiencies in the capital markets?

 

[grumpy]

and the resulting lower cost of capital for the firm

Unless this is an IPO or secondary offering, how is the cost of capital lower for THE FIRM? Most stock buys/sells are between investors and do not directly effect the firm.

Grumpy

 

[Gone4Good]

Unless this is an IPO or secondary offering, how is the cost of capital lower for THE FIRM?  Most stock buys/sells are between investors and do not directly effect the firm.
  Grumpy

Companies issue shares all the time, through DRIP plans, through stock awards and options, sometimes to finance large capital spending plans and especially for M&A. Many companies merge simply by exchanging shares without ever having to hold a secondary offering. A perfect example of this is AOL buying Time Warner in a share exchange in 2000.

Perhaps more importantly though, stock prices feed into companies' estimates of their weighted average cost of capital (WAC). The WAC is the hurdle rate companies use to evaluate internal investment decisions. If the stock price is "wrong" due to market inefficiencies then the company's hurdle rate will also be wrong and capital will be spent in ways that actually destroy value.

 

[sgeeeee]

. . .  It gives the best argument against indexing I've seen.  . .

All I can say is if this is the best argument against indexing, then there is no reasonable argument against indexing.

As long as index funds continue to beat 75% of active funds over 10 year periods and more than that over longer periods, arguments against indexing are nothing but hand-waving. Wake me up when that actually starts to change.

 

[grumpy]

Companies issue shares all the time, through DRIP plans, through stock awards and options, sometimes to finance large capital spending plans and especially for M&A.

For companies in the major indices, like the S&P 500, these types of share issuances represent an infintesimal percentage total shares outstanding and so do not have any substantial impact on a company's capital structure.

Grumpy

 

[greg]

Apocalypse,

I failed to see your point re: GE being owned in large quantities by index funds. The "Major Holders" listing you linked to at Yahoo Finance showed that of the top ten mutual fund holders, only 3 were index funds. That means 7 actively managed funds are making big bets on GE. Are you saying that a minority position (that which is owned by index funds) is causing huge distorting effects and inefficiencies in the capital markets?

Justin:

No, I'm saying everyone else is just doing "the pile on" with other monies and other related but different strategies. I'm working on a better response. Most everyone here wants some sort of absolute, statistically verifiable, hard truth response. It won't be that--because currently the numbers won't/can't show it. Remember what the article says: indexing works until it doesn't--just like the housing bubble, just like the tech boom. Some got off at the right time, some didn't. The statistics and numbers and reported facts looked great as the tech bubble was going up. I'm currently playing the near term natural gas pile on and the longer term gold pile on. The mid term oil pile on doesn't look to risky to me either--but that one is more of a worrier to me. I think a lot of the old Ben Graham-type values are gone from the market place at this point. Just speculation, but perhaps the only thing left in the world are future pile on situations.

I guess another way of saying it is "expect volitility down the road." But that would be a very extreme take on things that even I don't believe. But many non-bears have said it. I'll be back.

 

[Gone4Good]

For companies in the major indices, like the S&P 500, these types of share issuances represent an infintesimal percentage total shares outstanding and so do not have any substantial impact on a company's capital structure.

  Grumpy

Are you arguing that current equity prices do not impact a company's cost of capital? If so, I respectfully disagree.