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Why is more investors indexing a “bubble”? Is it just because of the growth line? While there surely must be some crappy indexes out there, one could argue tha

Why is more investors indexing a “bubble”? Is it just because of the growth line? While there surely must be some crappy indexes out there, one could argue that more indexing by (individual) investors is a sign of a more people understanding the difficulty of stock picking and harsh effects of management expenses on investment returns. I’m very happy indexing in my retirement portfolios, but am curious as to what the arguments against it are. The few I’ve read have seemed to be active fund managers scared at the prospect of losing their livelihood to a better product.

mcguire 9y ago
By definition, almost all investment money is in an index. What proportion of it is in low-cost index mutual funds vs. high-cost employer retirement and managed mutual funds is of interest only to the financial services industry, which makes more money in the latter case.
colorint 9y ago
>but am curious as to what the arguments against it are There's a "philosophical" problem to the effect of, at some point, what are you indexing? But what seems to me to be the more practical issue, and forgive me for this being half-formed, is that it seems like indexing is subtly the wrong thing to do (in a world consisting of only bad choices). The things being indexed are basically weights, for example, the relative capitalization of various stocks, based on some filtering criteria. In order to keep a fund on target with an index, they have to buy and sell according to those weights, and in principle, if the weights change, then the fund's holdings have to change accordingly. This would seem to me to introduce problems like, if there's a sell-off of some stock so that its price drops, then its capitalization will also drop (capitalization being number of shares times price per share), which would seem to reduce its weight in the index. This should then lead to index funds having a follow-on sell-off. (And likewise for exuberant buying.) So this would suggest to me that, if index funds come to dominate stock holdings, then they should both increase volatility, and result in their holders systematically "buying high and selling low." That is, because an index fund is not the same as an index, but it's in active feedback with the index computation method. There's also a potential issue, again depending on the level of buy-in, that one should see systematically increasing P/E ratios because of increased overall buying of stocks. That is, in the past, it was not typical for normal people to engage in regular stock purchases (which are held for decades). This would suggest lower dividend yields, which leaves one wondering whether 401ks will become what people think Social Security is, i.e., ever-rising P/Es serving as a transfer from the young to the old that requires continual workforce increases to maintain. Though I'm not in finance, these are just the things that occur to me in thinking, how would I implement an index fund, and what might that do to the system's dynamics.
AnimalMuppet 9y ago
The term "bubble" gets thrown around a lot, sometimes incorrectly. It doesn't just mean that money is flowing into an asset class. Let's take an S&P 500 index fund as an example. Vanguard or whoever does some marketing, and people decide that index funds are a good way to invest, and money flows into index funds. That's not a bubble. The economy starts doing well, and stocks go up, and a bunch more people decide that they want to be in the stock market, and so they put their money into an S&P 500 index fund, not because they really want to be in the stock market, but because it's what's going up. That's still not a bubble. Vanguard gets a bunch of money for its S&P 500 index fund, which it has to use to buy stock in the companies that compose the S&P 500. As a result of all the new money coming in, the stock in the S&P 500 companies go up - more than the fundamentals of their business indicate, more than stock in, say, the Russell 2000 goes up. Because the S&P 500 has gone up more, more money pours in to S&P 500 index funds. Now the S&P 500 is going up because of all the money being invested in it, and all the money is being invested in it because it's going up. That's a bubble - a positive feedback loop that has become detached from the fundamentals of the assets involved. That's a bubble, but it doesn't really get bad until borrowed money enters the picture. If people are borrowing money to invest in S&P 500 index funds, because the funds are going up faster than the interest cost on the borrowed money, now it's a bubble that can cause serious damage when it pops, because it may damage the lender as well as the borrower. So, for example, people were talking about bonds being in a bubble because bond prices were so high (extremely high by historical standards). That was a flight to safety, not a bubble. People were not buying bonds because they expected bond prices to keep rising, they were buying bonds because they expected other prices to keep falling.

mcguire 9y ago

By definition, almost all investment money is in an index. What proportion of it is in low-cost index mutual funds vs. high-cost employer retirement and managed mutual funds is of interest only to the financial services industry, which makes more money in the latter case.

colorint 9y ago

>but am curious as to what the arguments against it are There's a "philosophical" problem to the effect of, at some point, what are you indexing? But what seems to me to be the more practical issue, and forgive me for this being half-formed, is that it seems like indexing is subtly the wrong thing to do (in a world consisting of only bad choices). The things being indexed are basically weights, for example, the relative capitalization of various stocks, based on some filtering criteria. In order to keep a fund on target with an index, they have to buy and sell according to those weights, and in principle, if the weights change, then the fund's holdings have to change accordingly. This would seem to me to introduce problems like, if there's a sell-off of some stock so that its price drops, then its capitalization will also drop (capitalization being number of shares times price per share), which would seem to reduce its weight in the index. This should then lead to index funds having a follow-on sell-off. (And likewise for exuberant buying.) So this would suggest to me that, if index funds come to dominate stock holdings, then they should both increase volatility, and result in their holders systematically "buying high and selling low." That is, because an index fund is not the same as an index, but it's in active feedback with the index computation method. There's also a potential issue, again depending on the level of buy-in, that one should see systematically increasing P/E ratios because of increased overall buying of stocks. That is, in the past, it was not typical for normal people to engage in regular stock purchases (which are held for decades). This would suggest lower dividend yields, which leaves one wondering whether 401ks will become what people think Social Security is, i.e., ever-rising P/Es serving as a transfer from the young to the old that requires continual workforce increases to maintain. Though I'm not in finance, these are just the things that occur to me in thinking, how would I implement an index fund, and what might that do to the system's dynamics.

AnimalMuppet 9y ago

The term "bubble" gets thrown around a lot, sometimes incorrectly. It doesn't just mean that money is flowing into an asset class. Let's take an S&P 500 index fund as an example. Vanguard or whoever does some marketing, and people decide that index funds are a good way to invest, and money flows into index funds. That's not a bubble. The economy starts doing well, and stocks go up, and a bunch more people decide that they want to be in the stock market, and so they put their money into an S&P 500 index fund, not because they really want to be in the stock market, but because it's what's going up. That's still not a bubble. Vanguard gets a bunch of money for its S&P 500 index fund, which it has to use to buy stock in the companies that compose the S&P 500. As a result of all the new money coming in, the stock in the S&P 500 companies go up - more than the fundamentals of their business indicate, more than stock in, say, the Russell 2000 goes up. Because the S&P 500 has gone up more, more money pours in to S&P 500 index funds. Now the S&P 500 is going up because of all the money being invested in it, and all the money is being invested in it because it's going up. That's a bubble - a positive feedback loop that has become detached from the fundamentals of the assets involved. That's a bubble, but it doesn't really get bad until borrowed money enters the picture. If people are borrowing money to invest in S&P 500 index funds, because the funds are going up faster than the interest cost on the borrowed money, now it's a bubble that can cause serious damage when it pops, because it may damage the lender as well as the borrower. So, for example, people were talking about bonds being in a bubble because bond prices were so high (extremely high by historical standards). That was a flight to safety, not a bubble. People were not buying bonds because they expected bond prices to keep rising, they were buying bonds because they expected other prices to keep falling.