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This is fascinating. Selfishly though this seems to signal for investors of index funds (such as myself) that they will only continue to be good investments unl

This is fascinating. Selfishly though this seems to signal for investors of index funds (such as myself) that they will only continue to be good investments unless major government regulation occurs. Does anyone know of any investment risk to index funds if everyone is now doing it?

ams6110 8y ago
I don't consider myself very savvy in investing, but I guess if "half of all stocks" are owned by index funds that's a concentration of ownership that might be considered unnatural at best. I didn't read past the paywall but one good thing if more and more people own index funds then they are participating in the success of those corporations represented in that index. Might tend to tone down some of the shrill agitation that everything "corporations" do is evil and greedy.
pge 8y ago
one risk is that if too many people are invested in index funds (passive, not buying or selling based on new information), then the price of those stocks is determined by a small group of active investors
- bluGill 8y ago
  So long as the pool is large enough that doesn't matter. Index funds just need the price to be close to reasonable to work out. When the price is not reasonable index funds do well. In general active investors work to push the price to reasonable levels. Of course there is such a thing as price manipulation which active investors can try - if there are only a few and they work together this can work out. However the investors have incentive to cheat when working together as the cheater wins against his peers, thus this currently is confined to "penny stocks" (for example the company behind the stock doesn't exist anymore but they didn't properly delist their stock so technically it can be traded - you can buy such stocks for say a penny each and then hype them to suckers as the next big thing and sell for 10 cents each and make a killing - since the company doesn't exist no one else pays attention and the scam works.)
alehul 8y ago
Index fund investors are classified as "passive investors," while others are "active investors." The main investment risk to index funds growing is that, if everybody is a passive investor, then the passive investors are worse off as there are very few active investors who actually try and value companies appropriately. On the other hand, if the market is littered with active investors, then the market is likely more efficient and 'correct', and so you're (probably) better off as a passive investor.
- koboll 8y ago
  As an "active investor" your competition is HFT algos on servers located as physically close as possible to the stock market in order to achieve superhuman reflexes. Which you have absolutely zero hope of beating. I'd rather see slower, predictable gains than bet my nest egg trying to go toe-to-toe with hyperefficient machines -- or hand it off to some Manhattan finance bro making that bet on my behalf.
  - alehul 8y ago
    That's why being a passive investor is often the best route for the average person, unless you have the opportunity to invest in a successful fund that takes an active role, or you put in the effort (and have the skill/luck/whatever) to invest yourself. I'd point out, however, that your competition is usually not "HFT algos on servers located as physically close as possible," unless you are, yourself, a HFT trader. Even if you're buying a security for a few cents more because an HFT firm has corrected the price, if you're holding for weeks, months, or years... what's the difference? There's room for both of you to succeed, as long as your investment philosophies and holding periods differ that significantly.
  - wbl 8y ago
    Not necessarily true. If you are an active investor that doesn't necessarily mean the activities that compete with the HFT guys.
  - nradov 8y ago
    Stock pickers managing active mutual funds aren't competing with high-frequency traders at all. The human stock pickers are buying with the intent to hold for at least several days (usually even longer). If you want slow, predictable gains then invest in highly rated bonds. Handing investment decisions off to some Manhattan finance bro is unlikely to improve your long-term risk-adjusted returns.
jonbarker 8y ago
A risk is one of the options, which is a breakup of existing funds: "Force giant index funds to spin off their assets into a number of separate entities, each independently managed. Such a drastic step would—and should—face near-insurmountable obstacles, for it would create havoc for index investors and managers alike."
- bluGill 8y ago
  So long as the two broken up funds are both index funds it won't matter. Index funds all work the same way so a million tiny funds will have the same effect as one large one.
  - jonbarker 8y ago
    I believe breakups would drive up the expense ratio which is why Bogle said that it would be damaging to individual investors. Part of the reason why Vanguard is so cheap to operate is because of its size contributing to economies of scale. You can see small variations in the expense ratios now (for example Fidelity is slightly higher cost than Vanguard across most apples to apples comparison funds) for this reason.
  - joshcain 8y ago
    Theoretically, yeah, but like a lot of tech companies, index funds are a high-ish fixed cost and low marginal cost business. The staff/IT/compliance/etc. costs to run a fund don't scale linearly with invested assets so functionally a million tiny funds would be much more expensive to operate (collectively) than one big one. You'd have to have somebody at each fund voting in all those shareholder votes, right?
bluGill 8y ago
The risk is because index funds don't do stock analysis (instead they buy and hold all stocks) they will invest in bad companies and prop their price up. Then when the bad company goes bankrupt (as everyone paying attention knows will happen) the index funds are left holding all the stock suddenly worth nothing. Which is to say the traditional more expensive managed funds that actually pay attention to the fundamentals of the companies they invest in should see a comeback. While this style of fund is more expensive (because a human can only examine a few companies in a year in enough detail to decide if they are worth investing in - as a full time job you can maybe do 50) by investing only in companies that will do better than average they can beat the market (or shorting if you want to play companies that will do far worse than average). So far the low costs of index funds have made them a better investment despite them not investing in strong companies, but we should see the day where a managed fund can beat the index funds just because the index funds are leaving the advantages of analysis on the table. You can argue [meaning this might or might not be correct] that historically managed funds have done worse than index funds because there are so many managers that anytime there is a slight deal someone jumps on it before the deal is large enough to pay for the costs of finding it. However if you don't jump on it someone else will and they make something on the deal while you make nothing. Thus as index funds take over there will be more and more deals for the managers to find, and managers can wait until they are large enough to be worth the price. It will be interesting to see when/where the line is crossed.
- joshgel 8y ago
  I think this is almost true. It would be true if index funds held all the stock. But since they don't and managed funds still exist, the stock price will go down when managed funds decide to sell. When the stock price goes down, the shares become a lower fraction of the index, so the index funds will also sell some. I think the main point is that index funds still rely on traditional market players to effectively allocate risk. And as index funds take up more of the market, they become less able to do that. Right?
  - toast0 8y ago
    The index fund doesn't need to take any action to respond to price movement. When the stock price goes down, the shares become a lower fraction of the index and also a lower fraction of the fund's holdings. The fund has to manage holdings around fund purchases and redemptions, and when the index changes.
xkjkls 8y ago
I'd say this article probably overstates risks. US Equities are only about 30% passive, depending on how you measure it, and there probably is substantial run-rate for an even greater concentration. Here's a pretty good article: https://www.aqr.com/Insights/Research/Alternative-Thinking/Active-and-Passive-Investing-The-Long-Run-Evidence https://www.aqr.com/Insights/Research/Alternative-Thinking/A...

ams6110 8y ago

I don't consider myself very savvy in investing, but I guess if "half of all stocks" are owned by index funds that's a concentration of ownership that might be considered unnatural at best. I didn't read past the paywall but one good thing if more and more people own index funds then they are participating in the success of those corporations represented in that index. Might tend to tone down some of the shrill agitation that everything "corporations" do is evil and greedy.

pge 8y ago

one risk is that if too many people are invested in index funds (passive, not buying or selling based on new information), then the price of those stocks is determined by a small group of active investors

bluGill 8y ago
So long as the pool is large enough that doesn't matter. Index funds just need the price to be close to reasonable to work out. When the price is not reasonable index funds do well. In general active investors work to push the price to reasonable levels. Of course there is such a thing as price manipulation which active investors can try - if there are only a few and they work together this can work out. However the investors have incentive to cheat when working together as the cheater wins against his peers, thus this currently is confined to "penny stocks" (for example the company behind the stock doesn't exist anymore but they didn't properly delist their stock so technically it can be traded - you can buy such stocks for say a penny each and then hype them to suckers as the next big thing and sell for 10 cents each and make a killing - since the company doesn't exist no one else pays attention and the scam works.)

alehul 8y ago

Index fund investors are classified as "passive investors," while others are "active investors." The main investment risk to index funds growing is that, if everybody is a passive investor, then the passive investors are worse off as there are very few active investors who actually try and value companies appropriately. On the other hand, if the market is littered with active investors, then the market is likely more efficient and 'correct', and so you're (probably) better off as a passive investor.

koboll 8y ago
As an "active investor" your competition is HFT algos on servers located as physically close as possible to the stock market in order to achieve superhuman reflexes. Which you have absolutely zero hope of beating. I'd rather see slower, predictable gains than bet my nest egg trying to go toe-to-toe with hyperefficient machines -- or hand it off to some Manhattan finance bro making that bet on my behalf.
- alehul 8y ago
  That's why being a passive investor is often the best route for the average person, unless you have the opportunity to invest in a successful fund that takes an active role, or you put in the effort (and have the skill/luck/whatever) to invest yourself. I'd point out, however, that your competition is usually not "HFT algos on servers located as physically close as possible," unless you are, yourself, a HFT trader. Even if you're buying a security for a few cents more because an HFT firm has corrected the price, if you're holding for weeks, months, or years... what's the difference? There's room for both of you to succeed, as long as your investment philosophies and holding periods differ that significantly.
- wbl 8y ago
  Not necessarily true. If you are an active investor that doesn't necessarily mean the activities that compete with the HFT guys.
- nradov 8y ago
  Stock pickers managing active mutual funds aren't competing with high-frequency traders at all. The human stock pickers are buying with the intent to hold for at least several days (usually even longer). If you want slow, predictable gains then invest in highly rated bonds. Handing investment decisions off to some Manhattan finance bro is unlikely to improve your long-term risk-adjusted returns.

jonbarker 8y ago

A risk is one of the options, which is a breakup of existing funds: "Force giant index funds to spin off their assets into a number of separate entities, each independently managed. Such a drastic step would—and should—face near-insurmountable obstacles, for it would create havoc for index investors and managers alike."

bluGill 8y ago
So long as the two broken up funds are both index funds it won't matter. Index funds all work the same way so a million tiny funds will have the same effect as one large one.
- jonbarker 8y ago
  I believe breakups would drive up the expense ratio which is why Bogle said that it would be damaging to individual investors. Part of the reason why Vanguard is so cheap to operate is because of its size contributing to economies of scale. You can see small variations in the expense ratios now (for example Fidelity is slightly higher cost than Vanguard across most apples to apples comparison funds) for this reason.
- joshcain 8y ago
  Theoretically, yeah, but like a lot of tech companies, index funds are a high-ish fixed cost and low marginal cost business. The staff/IT/compliance/etc. costs to run a fund don't scale linearly with invested assets so functionally a million tiny funds would be much more expensive to operate (collectively) than one big one. You'd have to have somebody at each fund voting in all those shareholder votes, right?

bluGill 8y ago

The risk is because index funds don't do stock analysis (instead they buy and hold all stocks) they will invest in bad companies and prop their price up. Then when the bad company goes bankrupt (as everyone paying attention knows will happen) the index funds are left holding all the stock suddenly worth nothing. Which is to say the traditional more expensive managed funds that actually pay attention to the fundamentals of the companies they invest in should see a comeback. While this style of fund is more expensive (because a human can only examine a few companies in a year in enough detail to decide if they are worth investing in - as a full time job you can maybe do 50) by investing only in companies that will do better than average they can beat the market (or shorting if you want to play companies that will do far worse than average). So far the low costs of index funds have made them a better investment despite them not investing in strong companies, but we should see the day where a managed fund can beat the index funds just because the index funds are leaving the advantages of analysis on the table. You can argue [meaning this might or might not be correct] that historically managed funds have done worse than index funds because there are so many managers that anytime there is a slight deal someone jumps on it before the deal is large enough to pay for the costs of finding it. However if you don't jump on it someone else will and they make something on the deal while you make nothing. Thus as index funds take over there will be more and more deals for the managers to find, and managers can wait until they are large enough to be worth the price. It will be interesting to see when/where the line is crossed.

joshgel 8y ago
I think this is almost true. It would be true if index funds held all the stock. But since they don't and managed funds still exist, the stock price will go down when managed funds decide to sell. When the stock price goes down, the shares become a lower fraction of the index, so the index funds will also sell some. I think the main point is that index funds still rely on traditional market players to effectively allocate risk. And as index funds take up more of the market, they become less able to do that. Right?
- toast0 8y ago
  The index fund doesn't need to take any action to respond to price movement. When the stock price goes down, the shares become a lower fraction of the index and also a lower fraction of the fund's holdings. The fund has to manage holdings around fund purchases and redemptions, and when the index changes.

xkjkls 8y ago

I'd say this article probably overstates risks. US Equities are only about 30% passive, depending on how you measure it, and there probably is substantial run-rate for an even greater concentration. Here's a pretty good article: https://www.aqr.com/Insights/Research/Alternative-Thinking/Active-and-Passive-Investing-The-Long-Run-Evidence https://www.aqr.com/Insights/Research/Alternative-Thinking/A...