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If the allocation of assets to index funds approach 100%, wouldnt that distort the prices of stocks? Instead of the price reflecting the fundamentals of the bus
by AznHisoka 7y ago
If the allocation of assets to index funds approach 100%, wouldnt that distort the prices of stocks? Instead of the price reflecting the fundamentals of the business and earnings, it would simply reflect how the index is moving. A bad company with a dying business would not decline in price because money was flowing in its index.
And active managers would not short dying businesses if they realize everyone else was blindly plowing money to it because it belonged to an index. Thus worsening the situation. The price of a stock is no longer “efficient” and not a reflection of the information available to the entire market.
Personally I wish index funds were abolished, forcing everyone to pick and choose the companies they think will flourish or fail.
- cheerlessbog 7y agoAs the proportion increases, the market distortion you describe would increase, making it easier to pick stocks successfully. So the answer is: there will be an equilibrium and we have just not reached it.
- xchaotic 7y agoIt would then still seem sensible to invest in an index fund for now. Until we find that equilibrium
- cheerlessbog 7y agoThat's my reasoning.
- anonymousDan 7y agoBut how to know when that equilibrium is reached? Even retrospectively how might someone spot temporary glitches where things have gone too far from looking at market prices?
- Scoundreller 7y agoWe really don’t. But what we do know is that passive index investors save 0.5%-2% per year of returns by being passive, and that makes up for a lot.
- gubbrora 7y agoYou can save that same amount by buying stock yourself (subject to availability in your account, I guess some retirement accounts offer only funds)
- Scoundreller 7y agoCould, but it’s a record keeping nightmare. And buy/sell commissions/friction. I’ll keep paying $1/3k p.a. to VTI in management fees.
- marcosdumay 7y agoIf you think the market is crazy because of mindless investing, you go and put your money on the clear winners. That's how equilibrium is reached. We don't get to know if you are a genius or an idiot, not even after the fact.
- cheerlessbog 7y agoActively managed funds' management fees will begin to rise?
- moorhosj 7y agoPotentially similar situation as the number of publicly traded companies continues to fall. Fewer companies available to invest in may inflate the price of those left.
- Scoundreller 7y agoWhich should just encourage companies to go public. Or encourage public companies to acquire more private ones. Or to float more stock instead of going to the bond markets. But big pension funds are also putting money into direct acquisitions instead of just buying stocks.
- pimmen 7y agoThe price drops to zero if the business dies because the stock gives you no voting power or dividends. Because the company is dead. So, if it's a dying business everyone is pouring their money into then every active manager would search the couch for every last penny to short it with. Which is why I don't believe index funds will make up 100% of all stock assets because people who do understand the market would exploit the index fund allocation and attract more capital, and the stock picks of those successful active managers would quickly be represented in the index.
- paulpauper 7y ago>Personally I wish index funds were abolished, forcing everyone to pick and choose the companies they think will flourish or fail. Indexing is just automated and systematized diversification. You cannot stop someone from diversifying their portfolio.
- AznHisoka 7y agoIf someone wants to diversify their portfolio, then they can go ahead and choose the companies they want to diversify with. Want to mix in some tech companies into your portfolio. OK, go pick Amazon vs. Oracle. Want to mix in a retail company? OK, go pick Lululemon vs Bed Bath and Beyond.
- SketchySeaBeast 7y agoAre you against managed funds entirely then?
- redisman 7y agoUnless you mean you want to make it illegal to buy stocks in more than 5 companies I don't see how this would be in any way enforceable. I would just Google "vanguard stock allocation fund X" and buy exactly those. I have 0 clue about the financials and business plans of any of those companies so why do you want to force me to use my time to hand pick stocks?
- jessriedel 7y agoI mean, in some sense anti-trust laws do this. But you're right it would be impossible/dysfunctional at the level of retail investors. More plausible is some sort of rule preventing a single index fund from taking large positions in multiple firms the same industry; retail investors could then invest in multiple index funds, achieving the same diversification but with increased difficulty of collusion. Unclear whether that would be worth the higher costs, though, and inevitable ambiguity about what constitutes an industry.
- gshdg 7y agoI don’t see how it’s any better for the market for investments to be dominated by retail investors who have neither the time nor the information they’d need to make informed choices about how to invest their retirement funds. My grandmother used to buy shares in Disney and GE because they were household names - which had little to do with their underlying financial health.
- throw0101a 7y ago> Personally I wish index funds were abolished, forcing everyone to pick and choose the companies they think will flourish or fail. Given that even the so-called professionals that manage active funds can't consistently beat the index, J. Random Schmoe has no chance: * https://www.aaii.com/journal/article/most-mutual-funds-do-not-outperform https://www.aaii.com/journal/article/most-mutual-funds-do-no... * https://www.ifa.com/articles/despite_brief_reprieve_2018_spiva_report_reveals_active_funds_fail_dent_indexing_lead_-_works/ https://www.ifa.com/articles/despite_brief_reprieve_2018_spi... PDFs: * https://us.spindices.com/documents/spiva/spiva-us-year-end-2016.pdf https://us.spindices.com/documents/spiva/spiva-us-year-end-2... * https://us.spindices.com/documents/research/research-fleeting-alpha-evidence-from-the-spiva-and-persistence-scorecards.pdf https://us.spindices.com/documents/research/research-fleetin...
- Scoundreller 7y agoMaybe. J Random Schmoe may do better because they’re investing their own money. The money manager managing JRS’ money on their behalf may make choices that help our MMM’s best friend more than anything else. Great for MM, but terrible for JRS.
- SketchySeaBeast 7y agoHow is that a good long term play for the money manager? He loses everyone but his buddies money and that means people are going to go to him?
- Scoundreller 7y agoMaking money for your friend and losing the money of people that that don’t even knoW you pays off (before the fact, or after).
- asdfasgasdgasdg 7y agoThere are plenty of studies that make it clear just how good J Random Schmoe's odds are of succeeding. (They're terrible.) we should not be talking about this as if the question is still open. The time before index funds was great for bankers, for money managers, and for brokers. It was terrible for the public. E.g. https://www.umass.edu/preferen/You%20Must%20Read%20This/Barber-Odean%202011.pdf https://www.umass.edu/preferen/You%20Must%20Read%20This/Barb...
- jandrewrogers 7y agoThere is an equilibrium point between indexed and non-indexed portfolios in terms of optimizing expected returns. Capital will move to whatever portfolio type is giving the best returns if too much of the market is composed of one or the other. More money moving into indexing makes it easier to outperform the index because there are fewer investors competing to profit from mis-priced equities, making those positions cheaper to acquire. Anecdotally, I find it easier to outperform the indexes today than it was fifteen years ago. Even if the entire market is indexing, there are still fundamental mechanisms that will keep it responsive. Markets are indexed in many ways depending on what aspect of the market the indexes are trying to capture, and these different indexes weight and value the underlying stocks differently, with some indexes outperforming others which will drive allocation of capital to different indexes. And at the extremes, over-valuation is addressed by bankruptcy and under-valuation is addressed by taking a company private, removing companies from the market entirely.
- conanbatt 7y agoTheres enough people actively trading that the market is relatively efficient. You are correct that if index funds reached 100% it would be crazy, but index funds would start performing worse than the market when they got to 99%, which means more would go to actively managed, til 98%, etc etc. There is definitely going to be a balance point where active > passive. And we might know about it 5, 10 years from now, even if it already happened.
- OscarCunningham 7y ago> but index funds would start performing worse than the market when they got to 99% They can't perform worse than the market, because they own shares in exactly the same proportion as the market.
- rightbyte 7y agoThey should perform worse than the market becouse they own crasching stocks and don't own stocks that climb into eg F500 to replace the crashing one.. The only way to performe at market average is to own a proportional share of all stocks and have no transaction costs.
- conanbatt 7y agoIndex fund replicate indexes, they are not the indexes.
- paxys 7y agoThe closer the allocation gets to 100%, the easier it will be for actively managed funds to beat their returns. So it is essentially a self-correcting problem.
- OscarCunningham 7y agoWill it though? The index fund owns stocks in the same proportions as the active funds do in combination, so the active funds can't beat the index funds no matter how inefficient the market gets.