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Index funds are by all evidence the better choice for the average individual, but they present something of a chicken and egg problem. To set the price of the

by entee 11y ago

Index funds are by all evidence the better choice for the average individual, but they present something of a chicken and egg problem. To set the price of the index, you need people buying and selling individual stocks. If everyone owned index funds, there would be no index. What is the percentage of the market owned/run by index funds where the premise of following an index starts to break down? The article says we haven't reached it, and that at that point active management approaches will regain an upper hand. Still, I wonder if it's true and the broader question remains.

HappyTypist 11y ago
As the article days, as index investing becomes more prevalent then the potential profits from price discovery also increases. This should lead to more active investing, correcting the imbalance. Ultimately, index investing returns (before fees) should equal or nearly equal aggregate active investing returns (before fees). This makes index investing /always/ being a better option.
- meric 11y ago
  The additional profit from active investing and price discovery will come from timing a market where momentum from index funds has clearly overshot fair value to risk. I think we're over that point, or perhaps I'm rationalising my own active investment.
randomname2 11y ago
On why index funds are not such a safe bet necessarily: http://charleshughsmith.blogspot.com/2016/01/the-illusion-of-safety-index-funds-are.html http://charleshughsmith.blogspot.com/2016/01/the-illusion-of...
- yason 11y ago
  To quote: "What is left unsaid is that if the broad market declines 50%, index funds also plummet 50%." The article is just stupid. If someone doesn't realize that the index funds will go up and down based on the very market they're indexing, and that all markets go up and down all the time, maybe that someone should just consume their money so that people with more wits can take better care of them. Who would be such an idiot to claim they're "safe" in the first place? Any investing is never "safe": you can always risk losing part of your money, even if you invest in a house. Not investing your money isn't safe either. Indexes can certainly dip for years: that's why you manage your risk and only invest money you don't need that much so that you don't have to cash in your investment during bad times. As long as the economy grows the growth will eventually be reflected in the indexes. Even a single 10-year period with a common stock index lower in the end rather than in the beginning would be, in practice, a rare occasion. Most depressions are over in a few years. Some continents can tank longer but you will want to buy indexes from different areas of the world anyway. Or you can only buy your local indexes, making sure you will yourself go up and down with the indexes you buy. An index will grow a few percent annually in the average, compounded. This is over decades which imply bad years and very good years. To buy the most passive index funds that have the smallest operating costs and letting your money sit in there is more and more likely to beat active funds and individual stock picking simply by waiting for the years to go by. Any costs saved by skipping active management fees or stock transaction fees will accumulate into your earnings instead.
  - iaskwhy 11y ago
    Can you expand on "Not investing your money isn't safe either."?
    - mseebach 11y ago
      Cash is at the whim of the government. When Icesave crashed in 2008, the Icelandic government refused to honour deposit insurance. I haven't followed the case, but it seems that depositors have started getting their money back. Cyprus confiscated 48% of all uninsured deposits in 2013, IIRC, at the time, they considered digging into the insured deposits as well. Greece was on the brink of leaving the Euro, imposing strict capital controls for over a month last summer. Had they left the Euro, all deposits would like have been forcefully converted to a new non-Euro currency, worth substantially less. Finally, practically all mature countries (ie. those issuing cash you might want to hold) maintain some level of inflations, so you have a constant, negative return on any cash holdings. Even US treasury bonds and UK gilts, which isn't cash, and isn't "not investing", but is among some of the absolute safest investments, just barely keeps up with inflation.
      - iaskwhy 11y ago
        I understand your point but the specifics about the European Union countries have changed a little since 2008, meaning nowadays all EU countries banks savings are really saved in any case up to 100k euros. This way, isn't money (up to 100k euros) considered safe in your view? Inflation is something you still need to keep your eyes on but was there ever a case (say, in the last 10, 20 years) in the EU were inflation was higher than the median savings account interest rates? I honestly have no idea but I know for sure since 2011 interest rates have always been higher than the inflation rate in the UK, for example. If this were a fact of savings accounts in the EU then inflation is not really something to be affraid of. Obviously I'm using "save" as "making just a bit of a money while taking zero risk".
        valdiorn 11y ago
        Cash is eroded away by inflation. If your currency hits high inflation for years continuously, like we had in Iceland (yes, I'm from there), going up to 25%, your cash isn't worth shit in 5 years time. I've experienced that. My parents experienced that. They had no "investments", kept their money in low-interest savings accounts, yet somehow their life savings was no longer enough to buy a used Toyota. Want to get more strange? What about war? How much is your money worth in case WW3 breaks out? Hardly likely? sure. Is it possible? absolutely. The point is, nothing is "safe", just different levels of risky.
shoo 11y ago
this is a somewhat obvious comment, but the notion of "an average individual" and "everyone" is very different. some people can specialise in price discovery as their occupation, and some people can specialise in growing sweet potato, or teaching kids, or nursing, or what have you. the former person can spend their time and energy learning how to pick stocks by hand, and influence the market, and the latter people can spend their time and energy learning and doing other useful things, and they can invest in index funds. Here's a completely different angle of attack: suppose I believe that the market doesn't price things correctly, and that some countries/sectors/companies are over valued, and some are under valued. in general, for some arbitrary set of of unpopular beliefs, there isn't an index fund I can buy into that is a good approximation of my beliefs. Even worse, it probably isn't possible for me to build a portfolio by linearly combining different index funds to approximate my desired portfolio allocation. For example, suppose I want to invest in countries A,B,C,D,E and sectors U,V,W,X,Y,Z subject to ethical constraints K and L. It may be the case that for each of the countries I can buy an A-country-ETF, and a B-country-ETF, and a global-sector-U-ETF, and a global-ethical-K-ETF, and for large countries I may even be able to buy a country-C-sector-X-ETF, but I can't make a good approximation of my desired portfolio by adding linear combinations of these things together. I don't really want to buy an canned portfolio in the form of an ETF, I want to buy a custom portfolio, or a custom portfolio factory, say. But perhaps part of the success of ETFs for non-expert folk like me is that they'd prevent me from expressing my strange individual beliefs about the market (which will probably result in worse investment outcomes for me than if I just did something mainstream).
- Ntrails 11y ago
  Assume that average individual represents people who have jobs unrelated to analysing companies/markets and therefore are managing their money in spare time only. To me stock picking on the basis that you know better than the market is largely hubris. Most of the people I know who do it don't do any meaningful benchmarking so it's impossible to properly assess success. When the market goes up they made money (yaaay - I picked well) but when they lost money it's because the market went down (nothing I can do in the face of that). There are a decent number of people manually investing their pension and I genuinely think some proper requirements on reporting would be valuable for them.
yason 11y ago
Even if there's no trading and no price for stocks, if all shares of all publicly owned companies were owned by one big index fund the profits from all those companies would eventually be, one way or another, channelled and attributed back to the owners, i.e. the index fund itself. That alone would set a price for the index fund itself. The fact that there's a market outside of indexing allows the index funds to buy more stock with the dividends received. With no market the index fund would need to pass the dividends forward to the owners of the fund.
Spooky23 11y ago
The finance people claim that this market making function is uber efficient now thanks to algorithmic trading.
- mseebach 11y ago
  That's not quite the argument. The argument is that those who want to sell or buy a specific stock can do so, immediately, at the correct price with minimal transaction cost without worrying about identifying a counterpart etc. -- hence, market-making. In a world where everybody is invested in the index, and no-one is buying individual stocks, there is no market to make.
  - kasey_junk 11y ago
    That's not quite true. Theoretically there would still be a demand curve, that is some people want more or less of the big index at any particular time. That means that you could make a market bridging the demand gap. But, it probably would be very risky and thus very expensive. I'd guess the "big index" world would be very illiquid.
applecore 11y ago
The most important driver of portfolio performance is asset allocation, which doesn't change just because you're allocating among a set of index funds.

by entee 11y ago

HappyTypist 11y ago

As the article days, as index investing becomes more prevalent then the potential profits from price discovery also increases. This should lead to more active investing, correcting the imbalance. Ultimately, index investing returns (before fees) should equal or nearly equal aggregate active investing returns (before fees). This makes index investing /always/ being a better option.

meric 11y ago
The additional profit from active investing and price discovery will come from timing a market where momentum from index funds has clearly overshot fair value to risk. I think we're over that point, or perhaps I'm rationalising my own active investment.

randomname2 11y ago

On why index funds are not such a safe bet necessarily: http://charleshughsmith.blogspot.com/2016/01/the-illusion-of-safety-index-funds-are.html http://charleshughsmith.blogspot.com/2016/01/the-illusion-of...

yason 11y ago
To quote: "What is left unsaid is that if the broad market declines 50%, index funds also plummet 50%." The article is just stupid. If someone doesn't realize that the index funds will go up and down based on the very market they're indexing, and that all markets go up and down all the time, maybe that someone should just consume their money so that people with more wits can take better care of them. Who would be such an idiot to claim they're "safe" in the first place? Any investing is never "safe": you can always risk losing part of your money, even if you invest in a house. Not investing your money isn't safe either. Indexes can certainly dip for years: that's why you manage your risk and only invest money you don't need that much so that you don't have to cash in your investment during bad times. As long as the economy grows the growth will eventually be reflected in the indexes. Even a single 10-year period with a common stock index lower in the end rather than in the beginning would be, in practice, a rare occasion. Most depressions are over in a few years. Some continents can tank longer but you will want to buy indexes from different areas of the world anyway. Or you can only buy your local indexes, making sure you will yourself go up and down with the indexes you buy. An index will grow a few percent annually in the average, compounded. This is over decades which imply bad years and very good years. To buy the most passive index funds that have the smallest operating costs and letting your money sit in there is more and more likely to beat active funds and individual stock picking simply by waiting for the years to go by. Any costs saved by skipping active management fees or stock transaction fees will accumulate into your earnings instead.
- iaskwhy 11y ago
  Can you expand on "Not investing your money isn't safe either."?
  - mseebach 11y ago
    Cash is at the whim of the government. When Icesave crashed in 2008, the Icelandic government refused to honour deposit insurance. I haven't followed the case, but it seems that depositors have started getting their money back. Cyprus confiscated 48% of all uninsured deposits in 2013, IIRC, at the time, they considered digging into the insured deposits as well. Greece was on the brink of leaving the Euro, imposing strict capital controls for over a month last summer. Had they left the Euro, all deposits would like have been forcefully converted to a new non-Euro currency, worth substantially less. Finally, practically all mature countries (ie. those issuing cash you might want to hold) maintain some level of inflations, so you have a constant, negative return on any cash holdings. Even US treasury bonds and UK gilts, which isn't cash, and isn't "not investing", but is among some of the absolute safest investments, just barely keeps up with inflation.
    - iaskwhy 11y ago
      I understand your point but the specifics about the European Union countries have changed a little since 2008, meaning nowadays all EU countries banks savings are really saved in any case up to 100k euros. This way, isn't money (up to 100k euros) considered safe in your view? Inflation is something you still need to keep your eyes on but was there ever a case (say, in the last 10, 20 years) in the EU were inflation was higher than the median savings account interest rates? I honestly have no idea but I know for sure since 2011 interest rates have always been higher than the inflation rate in the UK, for example. If this were a fact of savings accounts in the EU then inflation is not really something to be affraid of. Obviously I'm using "save" as "making just a bit of a money while taking zero risk".
      - valdiorn 11y ago
        Cash is eroded away by inflation. If your currency hits high inflation for years continuously, like we had in Iceland (yes, I'm from there), going up to 25%, your cash isn't worth shit in 5 years time. I've experienced that. My parents experienced that. They had no "investments", kept their money in low-interest savings accounts, yet somehow their life savings was no longer enough to buy a used Toyota. Want to get more strange? What about war? How much is your money worth in case WW3 breaks out? Hardly likely? sure. Is it possible? absolutely. The point is, nothing is "safe", just different levels of risky.

shoo 11y ago

this is a somewhat obvious comment, but the notion of "an average individual" and "everyone" is very different. some people can specialise in price discovery as their occupation, and some people can specialise in growing sweet potato, or teaching kids, or nursing, or what have you. the former person can spend their time and energy learning how to pick stocks by hand, and influence the market, and the latter people can spend their time and energy learning and doing other useful things, and they can invest in index funds. Here's a completely different angle of attack: suppose I believe that the market doesn't price things correctly, and that some countries/sectors/companies are over valued, and some are under valued. in general, for some arbitrary set of of unpopular beliefs, there isn't an index fund I can buy into that is a good approximation of my beliefs. Even worse, it probably isn't possible for me to build a portfolio by linearly combining different index funds to approximate my desired portfolio allocation. For example, suppose I want to invest in countries A,B,C,D,E and sectors U,V,W,X,Y,Z subject to ethical constraints K and L. It may be the case that for each of the countries I can buy an A-country-ETF, and a B-country-ETF, and a global-sector-U-ETF, and a global-ethical-K-ETF, and for large countries I may even be able to buy a country-C-sector-X-ETF, but I can't make a good approximation of my desired portfolio by adding linear combinations of these things together. I don't really want to buy an canned portfolio in the form of an ETF, I want to buy a custom portfolio, or a custom portfolio factory, say. But perhaps part of the success of ETFs for non-expert folk like me is that they'd prevent me from expressing my strange individual beliefs about the market (which will probably result in worse investment outcomes for me than if I just did something mainstream).

Ntrails 11y ago
Assume that average individual represents people who have jobs unrelated to analysing companies/markets and therefore are managing their money in spare time only. To me stock picking on the basis that you know better than the market is largely hubris. Most of the people I know who do it don't do any meaningful benchmarking so it's impossible to properly assess success. When the market goes up they made money (yaaay - I picked well) but when they lost money it's because the market went down (nothing I can do in the face of that). There are a decent number of people manually investing their pension and I genuinely think some proper requirements on reporting would be valuable for them.

yason 11y ago

Even if there's no trading and no price for stocks, if all shares of all publicly owned companies were owned by one big index fund the profits from all those companies would eventually be, one way or another, channelled and attributed back to the owners, i.e. the index fund itself. That alone would set a price for the index fund itself. The fact that there's a market outside of indexing allows the index funds to buy more stock with the dividends received. With no market the index fund would need to pass the dividends forward to the owners of the fund.

Spooky23 11y ago

The finance people claim that this market making function is uber efficient now thanks to algorithmic trading.

mseebach 11y ago
That's not quite the argument. The argument is that those who want to sell or buy a specific stock can do so, immediately, at the correct price with minimal transaction cost without worrying about identifying a counterpart etc. -- hence, market-making. In a world where everybody is invested in the index, and no-one is buying individual stocks, there is no market to make.
- kasey_junk 11y ago
  That's not quite true. Theoretically there would still be a demand curve, that is some people want more or less of the big index at any particular time. That means that you could make a market bridging the demand gap. But, it probably would be very risky and thus very expensive. I'd guess the "big index" world would be very illiquid.

applecore 11y ago

The most important driver of portfolio performance is asset allocation, which doesn't change just because you're allocating among a set of index funds.