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Interesting comment on that article: Index investing (applied to extremely wide market indexes) makes an assumption that there will be a continuous and infinit

• akg_67 16y ago
  I have several concerns with index fund/ETF investing: 1. How much of the underlying stocks, that make up the Index, are really owned by the Index fund/ETF? I doubt that such funds/ETF actually own 100% of the required underlying stocks, may be using some sort of option/hedge strategy. 2. In what scenario, not owning the actual underlying stocks can be detrimental to index fund/ETF? I am looking for what may cause failure of such funds/ETF and who may lose. 3. Is index fund/ETF investing artificially inflating price for underlying stocks compared to price of the rest of the non-index stocks in the market? 4. Can index investing cause Index "Bubble"?
  • joelhaus 16y ago
    1. An index is generally creared to the target mwarket.
  • regularfry 16y ago
    The problem is that "ETF" is actually quite a broad term. As far as I can tell, many ETF's do run a sort of "fractional reserve" ratio. There was an article here not long ago wringing its hands over that danger which I can't find right now. The answer to 2 I think depends on how dividends are handled. Obviously if you hold the shares yourself, you control what happens to the dividends, and are free to take them or reinvest them as you wish. For 3, it depends on the ratio of index trackers to managed funds in the market, but yes, this can have a noticeable effect. A share price always dips when the it's removed from one of the larger indices; you can see an example here: http://uk.finance.yahoo.com/q/bc?s=TATE.L&t=2y&l=on&z=l&q=l&c= http://uk.finance.yahoo.com/q/bc?s=TATE.L&t=2y&l=on&... - they were removed from the FTSE100 in March 2009.
  • sebilasse 16y ago
    For European ETF: 1.) Depends on the ETF. There is a) Full Replication. All stocks are 1 to 1 in the ETF. b) Swap based. EU swap ETFs can have up to 10% (but not more) in swap (what you mean by option/hedge), the rest is stocks. Oftentimes ETF issuers have an insurance on those swaps. If the swap counterparty goes bankrupt you loose that 10%. c) optimized sampling. You have different stocks (or not all of that index) in your ETF. The idea is to find stocks that corelate closely to those in the index. 2.) By buying the ETF you "own" the stocks. ETF are regulated like mutual funds (at least in EU). 3.) ETF are only a small fraction of the worldwide trade. But obviously if your company gets into a popular index (s&p 500) you can be quite happy. 4.) If everybody would only invest in indices, the market won't play anymore and it would be smarter to buy individual stocks again. This is the index investing paradox. But very unlikely to happen.
    • eru 16y ago
      About 4: Active investor could get a better performance than passive investors, if that situation would arise.
  • borism 16y ago
    1. read the prospectus. if the fund is comprised of stocks as opposed to derivatives it will be comprised of stocks. Of course fund will only buy whole and large amounts of shares, so say you put 1 ETF share worth $100, the fund won't be hurrying to buy shares with it, until they got $1000000 to start buying wholesale. 2. Of course if fund is derivative based all risks associated with derivatives come into play for fund investors. Same is true for any securities that are owned by funds - their risk is transferred to shares of fund. But I think you're familiar with risks associated with equity investing. 3. Maybe, maybe not, depends on stocks and market conditions. Of course the company is "more valuable" if it's included in some popular index like S&P, but then again ETF's and funds can make purchases wholesale, so there might be some benefit too. 4. Yes, but since traditional non-derivatives based funds are linked 1-to-1 to underlying shares, I don't see a huge problem. Unlike with derivatives-based funds.
    • yummyfajitas 16y ago
      Of course fund will only buy whole and large amounts of shares, so say you put 1 ETF share worth $100, the fund won't be hurrying to buy shares with it, until they got $1000000 to start buying wholesale. The ETF will actually never buy the shares. You can only buy existing ETF shares from other traders. ETF shares are created by large financial institutions - JPM/GS/other big players have the option to make an in-kind trades of share in securities for ETF shares. I.e., if an ETF is 50% MS and 50% AAPL, a large trader can trade 50k shares of AAPL and 50k shares of MS for 100k shares of the ETF. (Similarly, they can perform the reverse trade.)
      • borism 16y ago
        I don't quite understand what you're saying. From what I understand when the ETF achieves cash position needed to generate 1 creation unit (usually 50k ETF shares, as you correctly point out), then the fund is absolutely required to purchase underlying shares that index it's tracking requires it to hold. It can't just hold cash and promise to track index nevertheless. Or do you mean that first comes the Creation Unit, and then people can buy shares in ETF? In case of ETN there's absolutely no obligation to purchase anything, as they're simply debt of issuer; a promise to repay you in the future according to predetermined index or underlying movement. Maybe you meant ETNs? P.S. I re-read what you wrote, and I think what you're saying is that large institutions are intermediaries between ETF and investor. That is absolutely correct, and probably is so 99% of the time in the market anyway regardless of whether shares purchased are of individual companies or funds. But ETF is still required to hold the assets it states it will hold, that was my point.
• paraschopra 16y ago
  This has crossed my mind a lot of times and I think the comment is right - market capitalization of index cannot increase to infinity. There is a finite number of companies that the Index is comprised of and there has got to be a theoretical upper limit to that. Moreover, the investment psychology also comes into play here. The growth rate of index may slow down as it becomes large because investors always compare today's index with the previous values and are likely to conclude that the index is "over-valued" if it keeps rising. I'll be curious to find evidence of deceleration as the index value rises.
  • ars 16y ago
    So long as we keep making more humans the index can keep growing. Our current culture and economy is based on growth. If it were ever to stop, it would be a catastrophe worse than any Malthusian catastrophe. It's a good thing the planet is so big. (And despite nay-sayers there is actually plenty of space and resources left.)
    • bh42 16y ago
      Actually population growth all over the wold is slowing down. China is already at almost neutral and growth is even slowing in India and Africa. And a static or shrinking population would have an adverse affect on total market cap, however it would also mean a great job market, because even as the economy shrinks the labor pool would shrink faster. So your investments would not do well, but you'd always be able to get a high paying job.
    • TGJ 16y ago
      Would you care to elaborate on your sources of how there are plenty of resources left? (And despite what you say, your wrong) Does putting it in parentheses make it true? There is an upper limit on global population and resource replenishment.
• wazoox 16y ago
  Out from my crystal ball : Financial markets can't beat the real economy forever. As a bet on the future growth, they must return to reality from time to time. Furthermore, as growth as we've known it will most probably soon end forever (or for the long term at least), financial markets are on for some future "correction" of humongous proportions when the sovereign debts will be wiped out by inflation.
• cynicalkane 16y ago
  Well, 1) The world is getting bigger over time. 2) The world's industry, per capita, is getting more valuable over time. 3) Even if the first two were untrue, there is still a time value to money. People will spend capital to get value immediately, and investing is the opposite of that.
  • a5seo 16y ago
    This is a question of economic growth, which this paper handily explains... http://www.stanford.edu/~promer/EconomicGrowth.pdf http://www.stanford.edu/~promer/EconomicGrowth.pdf If you believe it's feasible for economic growth to continue, then you believe it's feasible for the indexes to continue to rise, perhaps to something that rounds to infinity (at least for my purposes).
• e40 16y ago
  I think this has to do with the age distribution in Western countries. As the baby boomers retire, they no longer are adding but start removing funds from the system. A friend and I talked about this 20 years ago when 401(k)'s became the rage, lamenting that we were on the wrong side of the boom.
  • eru 16y ago
    When those old people take capital out of the system, shouldn't your remaining capital become more valuable for its scarcity?
• SkyMarshal 16y ago
  Warren Buffet said sort of the same thing in one of his annual shareholder letters a few years ago. That exponential economic growth has natural limits, and that if we extrapolate the stock market's 20th century returns to the 21st century, you end up with a mind bogglingly (and unrealistically) large market cap in 2099. I forgot what year he wrote that, but it was sometime between 2006 and now. I don't have time to dig it up and find it, but here are his letters for anyone interested: http://www.berkshirehathaway.com/letters/letters.html http://www.berkshirehathaway.com/letters/letters.html Edit: Got myself curious, had to find it. Here it is, from the 2007 letter, ps 18-19: "Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved. The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss. This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been. How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century. Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last. It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome? Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high-priced managers (“helpers”). Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win. I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double- digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees."
• eru 16y ago
  This doesn't take dividends into account. Look at the DAX index, it includes re-invested dividends, and thus mirrors the actual performance of a passive-investment strategy better than a pure-stock price index.