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A bigger problem with index funds is the inherent bias they create towards consolidation of capital at the top. A company that becomes part of the S&P 500 will

by bcg1 11y ago

A bigger problem with index funds is the inherent bias they create towards consolidation of capital at the top. A company that becomes part of the S&P 500 will automatically have bi-weekly buyers of their shares as people pump money into index funds via payroll deduction. Nearly every piece of mainstream financial advice in the US suggests such behavior... "d% of mutual funds fail outperform the S&P 500" etc. Of course such comparison ignores transaction costs, administrative costs, risk, diversification across asset classes, et al. However, it leads to many people who want to "Set it and forget it" to just buy the S&P 500 index companies automatically every 2 weeks, pumping up the values of large cap corporations whether they perform well or not. I know that companies don't necessarily benefit directly from an increasing stock price, but in reality it allows them to raise capital by issuing new shares with less dilution. Also it makes it costlier for smaller competitors to raise capital, crowding out competition. At the end of the day, the "antitrust" question is not about Apple v. Microsoft... it is moving more in the direction of "Apple & Microsoft" vs. anyone trying to claw and scrape their way into the game.

eevilspock 11y ago
Yet another addition to my list of Matthew Effect examples and how this effect may be enemy number one, undermining entirely the notion that an unregulated free market produces a level-playing field and a meritocracy.
- brc 11y ago
  1) There are no 'unregulated free markets' 2) Nobody -ever- has said that an 'unregulated free market produces a level playing field and a meritocracy' The facts are that a regulated and controlled market with freedom of economic action produces the best outcomes for a population as a whole, when measured in life expectancy, social mobility and and even environmental cleanliness. Every other system that has been tried produces far worse outcomes across all these measures. There's a persistent adolescent thought pattern running these days which says something like 'free market? Huh? Where's my lamborghini? I got nuthin' but student debt and no job' This kind of thinking should be avoided in order to make progress on the topic.
anigbrowl 11y ago
transaction costs, administrative costs, risk These are exactly the things that you generally minimize by buying an ETF (although obviously everything is in the same asset class by definition).
- exelius 11y ago
  Yeah, I think that's exactly what OP was saying. When a fund says "we beat the S&P index fund by 5%", the actual returns to the individual may be very close to what you get from an index fund. After fees are taken into account, few mutual funds (or hedge funds for that matter) can beat an ETF on a consistent basis. Mutual funds have their place (large, pooled plans like 401ks where there's enough money involved that fees can be negotiated come to mind); but they're probably not the best option for an individual investor. I always recommend newbie investors put most of their equity holdings in an S&P ETF for this reason; the returns on a mutual fund may be slightly higher in good years, but they'll almost always be worse in bad years.
  - tormeh 11y ago
    I'm very much not an expert, but wouldn't something more diversified than S&P be better? Isn't that the one free lunch? My money (as a student that's not much) is invested in a fund that tracks the MSCI All Country World Index, which was the most diversified Index fund I could find.
    - theseatoms 11y ago
      Yes, a more global approach is technically more diversified, but you have to make sure the fund's holdings match the name on the tin (and that the expense ratio isn't too high). I wouldn't call it a free lunch though. Very much the opposite. You're investing in the global market portfolio in order to avoid a potentially costly lunch (i.e. fees, trading costs, not keeping up with the market return, etc... I've stretched this analogy too far, I know)
    - ghaff 11y ago
      Depends on how larger company stocks are doing relative to a broader slice of the market. Same for US vs. various international indexes. Even if you're diversified in a number of different index funds, that doesn't mean you should necessarily be "forced" to invest, for example, in areas of the world that seem to have systemic issues (at least with respect to stock market performance). With respect to US equities, the S&P 500 and the Russell 4000 have performed fairly similarly over the past 5 years; which has performed better depends on the time period you look at. The NASDAQ has been a little bit higher overall but, of course, it also had a bigger drop if you look at a longer horizon.
exelius 11y ago
I would argue that the impact of these "buy and hold" investors on share price is minimal. There's so much liquidity these days that any one class of investor should have a minimal impact on the share price. The index funds end up moving WITH the market, so any downward (or upward) trend will be followed by whatever balancing algorithm they use. Your big swings in share price are still going to be driven by HFT algo traders, activist investors, hedge funds, etc. I do agree that companies in the S&P 500 have an oversized advantage in raising capital, but if you remove index funds from the picture, I think the mere existence of the index would have a similar effect (this could be researched historically, but I don't have the time/interest to do so). On the flip side, any stock in the S&P is going to have limited arbitrage opportunity due to the level of liquidity they get from index fund rebalancing, etc.; so algo traders looking at specific plays may want to find an asset with lower liquidity and fewer eyes watching it. As with anything in finance, there is a play available on both sides of the field and they tend to balance each other out.
- vegabook 11y ago
  Good point. Actually there is a thriving segment of the broker and hedge fund market whose entire game is figuring out which stocks will have their weights changed at each new index rebalancing, and "front-running" the index funds who can't do anything until it becomes official. Thus they profit off what is a market inefficiency, scraping value from the passive guys, which in the long run could I suppose limit the index fund phenomenon (though not the indices themselves).
  - sparky_z 11y ago
    I agreed with this argument until very recently when another article by Matt Levine changed my mind on the subject. http://www.bloombergview.com/articles/2015-07-07/can-you-really-game-index-funds- http://www.bloombergview.com/articles/2015-07-07/can-you-rea... Essentially, if the "front-runners" (not really a correct term, since nothing illegal is going on) weren't doing this, then the index funds would have to pay a huge premium to buy large amounts of stock on extremely short notice. The "front-runners" are actually reducing the index fund's overhead costs (and, yes, being compensated by the market for doing it). They certainly aren't cheating the index fund investors out of anything, because their investments will track the market, regardless.
deleted 11y ago
[deleted]
hibikir 11y ago
It's precisely because of the administrative costs and transaction costs that the managed mutual funds are a bad idea: They don't outperform, in the long run, if just because their transaction costs. That's really the point: An unsophisticated investor should go with index funds over the alternatives. To beat the market regularly, you need non-public information or insight, and the market is large enough that having said insight consistently is something limited to the highly connected. Your argument against index funds, from a market perspective, is really more about putting all that money in large cap indices. Taking index funds to their conclusion, the ideal situation would be to use broader indices. Startups will still have to deal with venture capitalists, but that's for good reason: High risk, high reward investments aren't exactly what your typical index fund investor is interested in.
- bcg1 11y ago
  You make a good point, I really was only considering major large cap indices. I assume this is what most people mean when they talk about "index funds". I'm not really against index funds per se, I actually think they are a great way to invest if you identify a trend in a particular sector. And truthfully, I'm far from a trained financial expert, I'm just some dumb hacker that is rubbed the wrong way by the type of advice I outlined in my above comment.
  - qdog 11y ago
    I'm rubbed wrong by the people who present at "Brown Bag Retirement Advice Lunch Talks" and want me to buy into their managed funds. The index funds have overhead in the range of .02-.5% for the most part. The managed funds are largely 1.5% and I've seen some that charge as much as 2.5%! I'll let you do the math, but it's very hard to choose a managed fund that will outperform after fees vs. S&P 500 from say Vanguard. Most retirement accounts also don't allow individual stock purchases (at least mine doesn't), so the options are fairly limited for most people.
    - digikata 11y ago
      If you change jobs, one can always roll over 401k accounts to Individual Retirement Accounts instead of the next company's 401k program. At that point you can control your own retirement funds in the roll-over IRA. (As always check with your own tax advisers to see if that's a good idea for your specific situation).
prostoalex 11y ago
Seems like other market participants (hedge funds, individual investors) are providing a solution to this problem by analyzing inflows and outflows into such index funds and creating respective positions in case they think an index is over-bought or over-sold.
thedaveoflife 11y ago
Your theory directly contradicts the Efficient Market Hypothesis. If "dumb money" is flowing in to large cap funds, institutional investors should be able to take advantage.
- ajross 11y ago
  Exactly. And being a threshold, it also should be concentrated at the margin, where companies "just outside" the S&P500 should see some measurable benefit vs. the ones "just inside" the list. I'm not aware of any such analysis.
- bcg1 11y ago
  What if the efficient market hypothesis is not correct? I think that people like Warren Buffett and Jim Rogers might beg to differ with that theory.
  - nickff 11y ago
    Then it should be very easy to make money by buying S&P501+ and shorting the S&P500. If you believe the theory in the OP, you can bet on it (and against EMH) by doing this. The question is: how much are you willing to bet on it? P.S. In case you are wondering, I have bet a significant amount of money on the EMH being correct.
    - im3w1l 11y ago
      Bcg1 is not an ideal investor. He does not have an unlimited line of credit at top tier interest rate. Shorting S&P500 would be very dangerous for him. A better strategy would be to underweight S&P500, and overweight the companies that are the closest to being included.
      - nickff 11y ago
        What you are describing is a lower-risk strategy, but it has a lower payoff as well. If one is very sure that a stock is overvalued, shorting is the best (simple) strategy to profit from it; if one is less certain, your strategy is a good one.
rory096 11y ago
>Of course such comparison ignores transaction costs, administrative costs, risk, diversification across asset classes, et al. That's exactly why mutual funds underperform. Given the EMH, it makes more sense not to spend so much time on 'asset management' like that. If you believe the S&P is overvalued because too many people index to it, you can invest in broader index funds and, if you're correct, yield a higher return.
pbreit 11y ago
What's preventing an "active" manager from managing in a fashion similar to an indexer? It seems like with a few, inexpensive tweaks, it wouldn't be too difficult to beat the index.
- tobltobs 11y ago
  Like only buy the ones whole will go up in price?
  - pbreit 11y ago
    My guess is that if you back test a few simple filters that you could find a point or 2. The main differences between an index fund and active management is indexers reveal their portfolios and don't trade as much.
    - eru 11y ago
      Arbitrage opportunities disappear when people exploit them. The markets are `anti-inductive'.
- gnopgnip 11y ago
  The fees add up in the long term to reduce the overall returns.
  - pbreit 11y ago
    Part of acting like an index fund would be keeping fees low.
    - adestefan 11y ago
      Then just buy the index fund. I can buy an index fund that has fees of 0.2%. If the managed fund has fees of 1.2% that means it needs to beat the index by at least 1% to come out even. If you can beat an index by 1% while trying to replicate an index, then you're either a genius or cheating. The numbers are even worse if it's in a taxable account. That means you need to beat both the management fee and the taxes because you'll end up paying taxes for all the turnover too.
WalterBright 11y ago
You can also buy index funds for the broader market, like the Russell 2000.
eru 11y ago
Professional investors short-selling specific companies in the S&P 500 could undo some of these drawbacks.

by bcg1 11y ago

eevilspock 11y ago

Yet another addition to my list of Matthew Effect examples and how this effect may be enemy number one, undermining entirely the notion that an unregulated free market produces a level-playing field and a meritocracy.

brc 11y ago
1) There are no 'unregulated free markets' 2) Nobody -ever- has said that an 'unregulated free market produces a level playing field and a meritocracy' The facts are that a regulated and controlled market with freedom of economic action produces the best outcomes for a population as a whole, when measured in life expectancy, social mobility and and even environmental cleanliness. Every other system that has been tried produces far worse outcomes across all these measures. There's a persistent adolescent thought pattern running these days which says something like 'free market? Huh? Where's my lamborghini? I got nuthin' but student debt and no job' This kind of thinking should be avoided in order to make progress on the topic.

anigbrowl 11y ago

transaction costs, administrative costs, risk These are exactly the things that you generally minimize by buying an ETF (although obviously everything is in the same asset class by definition).

exelius 11y ago
Yeah, I think that's exactly what OP was saying. When a fund says "we beat the S&P index fund by 5%", the actual returns to the individual may be very close to what you get from an index fund. After fees are taken into account, few mutual funds (or hedge funds for that matter) can beat an ETF on a consistent basis. Mutual funds have their place (large, pooled plans like 401ks where there's enough money involved that fees can be negotiated come to mind); but they're probably not the best option for an individual investor. I always recommend newbie investors put most of their equity holdings in an S&P ETF for this reason; the returns on a mutual fund may be slightly higher in good years, but they'll almost always be worse in bad years.
- tormeh 11y ago
  I'm very much not an expert, but wouldn't something more diversified than S&P be better? Isn't that the one free lunch? My money (as a student that's not much) is invested in a fund that tracks the MSCI All Country World Index, which was the most diversified Index fund I could find.
  - theseatoms 11y ago
    Yes, a more global approach is technically more diversified, but you have to make sure the fund's holdings match the name on the tin (and that the expense ratio isn't too high). I wouldn't call it a free lunch though. Very much the opposite. You're investing in the global market portfolio in order to avoid a potentially costly lunch (i.e. fees, trading costs, not keeping up with the market return, etc... I've stretched this analogy too far, I know)
  - ghaff 11y ago
    Depends on how larger company stocks are doing relative to a broader slice of the market. Same for US vs. various international indexes. Even if you're diversified in a number of different index funds, that doesn't mean you should necessarily be "forced" to invest, for example, in areas of the world that seem to have systemic issues (at least with respect to stock market performance). With respect to US equities, the S&P 500 and the Russell 4000 have performed fairly similarly over the past 5 years; which has performed better depends on the time period you look at. The NASDAQ has been a little bit higher overall but, of course, it also had a bigger drop if you look at a longer horizon.

exelius 11y ago

I would argue that the impact of these "buy and hold" investors on share price is minimal. There's so much liquidity these days that any one class of investor should have a minimal impact on the share price. The index funds end up moving WITH the market, so any downward (or upward) trend will be followed by whatever balancing algorithm they use. Your big swings in share price are still going to be driven by HFT algo traders, activist investors, hedge funds, etc. I do agree that companies in the S&P 500 have an oversized advantage in raising capital, but if you remove index funds from the picture, I think the mere existence of the index would have a similar effect (this could be researched historically, but I don't have the time/interest to do so). On the flip side, any stock in the S&P is going to have limited arbitrage opportunity due to the level of liquidity they get from index fund rebalancing, etc.; so algo traders looking at specific plays may want to find an asset with lower liquidity and fewer eyes watching it. As with anything in finance, there is a play available on both sides of the field and they tend to balance each other out.

vegabook 11y ago
Good point. Actually there is a thriving segment of the broker and hedge fund market whose entire game is figuring out which stocks will have their weights changed at each new index rebalancing, and "front-running" the index funds who can't do anything until it becomes official. Thus they profit off what is a market inefficiency, scraping value from the passive guys, which in the long run could I suppose limit the index fund phenomenon (though not the indices themselves).
- sparky_z 11y ago
  I agreed with this argument until very recently when another article by Matt Levine changed my mind on the subject. http://www.bloombergview.com/articles/2015-07-07/can-you-really-game-index-funds- http://www.bloombergview.com/articles/2015-07-07/can-you-rea... Essentially, if the "front-runners" (not really a correct term, since nothing illegal is going on) weren't doing this, then the index funds would have to pay a huge premium to buy large amounts of stock on extremely short notice. The "front-runners" are actually reducing the index fund's overhead costs (and, yes, being compensated by the market for doing it). They certainly aren't cheating the index fund investors out of anything, because their investments will track the market, regardless.

deleted 11y ago

[deleted]

hibikir 11y ago

It's precisely because of the administrative costs and transaction costs that the managed mutual funds are a bad idea: They don't outperform, in the long run, if just because their transaction costs. That's really the point: An unsophisticated investor should go with index funds over the alternatives. To beat the market regularly, you need non-public information or insight, and the market is large enough that having said insight consistently is something limited to the highly connected. Your argument against index funds, from a market perspective, is really more about putting all that money in large cap indices. Taking index funds to their conclusion, the ideal situation would be to use broader indices. Startups will still have to deal with venture capitalists, but that's for good reason: High risk, high reward investments aren't exactly what your typical index fund investor is interested in.

bcg1 11y ago
You make a good point, I really was only considering major large cap indices. I assume this is what most people mean when they talk about "index funds". I'm not really against index funds per se, I actually think they are a great way to invest if you identify a trend in a particular sector. And truthfully, I'm far from a trained financial expert, I'm just some dumb hacker that is rubbed the wrong way by the type of advice I outlined in my above comment.
- qdog 11y ago
  I'm rubbed wrong by the people who present at "Brown Bag Retirement Advice Lunch Talks" and want me to buy into their managed funds. The index funds have overhead in the range of .02-.5% for the most part. The managed funds are largely 1.5% and I've seen some that charge as much as 2.5%! I'll let you do the math, but it's very hard to choose a managed fund that will outperform after fees vs. S&P 500 from say Vanguard. Most retirement accounts also don't allow individual stock purchases (at least mine doesn't), so the options are fairly limited for most people.
  - digikata 11y ago
    If you change jobs, one can always roll over 401k accounts to Individual Retirement Accounts instead of the next company's 401k program. At that point you can control your own retirement funds in the roll-over IRA. (As always check with your own tax advisers to see if that's a good idea for your specific situation).

prostoalex 11y ago

Seems like other market participants (hedge funds, individual investors) are providing a solution to this problem by analyzing inflows and outflows into such index funds and creating respective positions in case they think an index is over-bought or over-sold.

thedaveoflife 11y ago

Your theory directly contradicts the Efficient Market Hypothesis. If "dumb money" is flowing in to large cap funds, institutional investors should be able to take advantage.

ajross 11y ago
Exactly. And being a threshold, it also should be concentrated at the margin, where companies "just outside" the S&P500 should see some measurable benefit vs. the ones "just inside" the list. I'm not aware of any such analysis.
bcg1 11y ago
What if the efficient market hypothesis is not correct? I think that people like Warren Buffett and Jim Rogers might beg to differ with that theory.
- nickff 11y ago
  Then it should be very easy to make money by buying S&P501+ and shorting the S&P500. If you believe the theory in the OP, you can bet on it (and against EMH) by doing this. The question is: how much are you willing to bet on it? P.S. In case you are wondering, I have bet a significant amount of money on the EMH being correct.
  - im3w1l 11y ago
    Bcg1 is not an ideal investor. He does not have an unlimited line of credit at top tier interest rate. Shorting S&P500 would be very dangerous for him. A better strategy would be to underweight S&P500, and overweight the companies that are the closest to being included.
    - nickff 11y ago
      What you are describing is a lower-risk strategy, but it has a lower payoff as well. If one is very sure that a stock is overvalued, shorting is the best (simple) strategy to profit from it; if one is less certain, your strategy is a good one.

rory096 11y ago

>Of course such comparison ignores transaction costs, administrative costs, risk, diversification across asset classes, et al. That's exactly why mutual funds underperform. Given the EMH, it makes more sense not to spend so much time on 'asset management' like that. If you believe the S&P is overvalued because too many people index to it, you can invest in broader index funds and, if you're correct, yield a higher return.

pbreit 11y ago

What's preventing an "active" manager from managing in a fashion similar to an indexer? It seems like with a few, inexpensive tweaks, it wouldn't be too difficult to beat the index.

tobltobs 11y ago
Like only buy the ones whole will go up in price?
- pbreit 11y ago
  My guess is that if you back test a few simple filters that you could find a point or 2. The main differences between an index fund and active management is indexers reveal their portfolios and don't trade as much.
  - eru 11y ago
    Arbitrage opportunities disappear when people exploit them. The markets are `anti-inductive'.
gnopgnip 11y ago
The fees add up in the long term to reduce the overall returns.
- pbreit 11y ago
  Part of acting like an index fund would be keeping fees low.
  - adestefan 11y ago
    Then just buy the index fund. I can buy an index fund that has fees of 0.2%. If the managed fund has fees of 1.2% that means it needs to beat the index by at least 1% to come out even. If you can beat an index by 1% while trying to replicate an index, then you're either a genius or cheating. The numbers are even worse if it's in a taxable account. That means you need to beat both the management fee and the taxes because you'll end up paying taxes for all the turnover too.

WalterBright 11y ago

You can also buy index funds for the broader market, like the Russell 2000.

eru 11y ago

Professional investors short-selling specific companies in the S&P 500 could undo some of these drawbacks.