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I'm an index fund skeptic. What would happen in a world where everyone invested in index funds? Capital allocation would go haywire. You can't create value out

I'm an index fund skeptic. What would happen in a world where everyone invested in index funds? Capital allocation would go haywire. You can't create value out of nothing. ISTM that the more people push on index funds, the more overvalued equities in the index become relative to those outside the index. I'm not sure that retrospective analysis saying index funds are the best applies going forward in a world where index funds are much more popular than they were in the past.

branweb 6y ago
Not the op but I wish downvoters would comment giving their reasons. I remember seeing something about this in the atlantic a while back, and it would be good to know if/why it's a bad argument.
- quotemstr 6y ago
  There's this weird social energy surrounding index funds that's very aggressive about preaching that they're the only viable option and that everything else is ridiculous. To be honest, this energy is another input that increases my skepticism of the whole thing. These days, whenever you see an argument downvoted instead of rebutted, there's likely something to it.
  - guenthert 6y ago
    I didn't downvote the earlier comment (and wouldn't as I'm quite clueless about financial matters), but felt the need to downvote another comment in an unrelated article recently. There I noticed, that once I applied the downvote, I couldn't see the comment being downvoted anymore. I meant to reply then to that comment on why I downvoted the comment, but couldn't anymore. I guess, that's the reason why one sees here so many downvotes by anonymous cowards.
  - mancerayder 6y ago
    I think voting can mean different things to different people. Some people upvote or downvote because they agree or disagree. They view it as a "vote" for the opinion. Others upvote or downvote because they thing the argument is strong or weak, or maybe because someone said something nice and positive to another person or someone said something mean or hostile to another person. I strongly favor the second approach.
  - hansjorg 6y ago
    Ever since Vanguard started there has been a constant barrage of anti index fund propaganda in the US. One of the early slurs was that index funds were communism (pretty daft, but probably effective in the US). The latest is this scaremongering "what if all investment were into index funds" (answered several times in this thread). From the perspective of index fund advocates, unsophisticated investors are systematically getting ripped off and the daft propaganda only adds to the offense. This is probably why you're picking up an aggressive preachy vibe from advocates. The empirical data is however unambiguous and there is now a lot of it.
  - imtringued 6y ago
    Index funds allow amateurs to make money without losing it to "competent" active fund managers. That's all there is to it. You might not understand how many middlemen insert themselves between the amateurs because you're not one of them.
- jdhn 6y ago
  I bet skeptics would say that if you steer people away from index funds, then they may put it in high fee active index funds that generate about the same return as the passive index funds. Personally, I think that as more people put their money into index funds, active funds may look more attractive as they can potentially exploit market misprices quicker than passive funds can, but that's just me.
- JulianWasTaken 6y ago
  Not a downvoter (nor a financial expert) but to check the argument seems at least reasonable to check whether the proportional return of Vanguard funds has decreased as the fractional amount of money invested with them vs. the total stock market has increased. Seems unlikely the answer is yes (probably because in fact you are not investing in "nothing" -- there's value in having money itself, same as interest at a bank, and you are investing in giving that money to lots of companies, not just one, and that's what you're making profit off of. So long as money generates money, why should the return taper off?) Probably an interesting number itself knowing what the fractional amount of money flowing through Vanguard is as a proportion of the total.
  - csmiller 6y ago
    By purchasing stock (not at ipo/sep), you aren’t giving money to companies, you are buying the share from another entity.
mensetmanusman 6y ago
Because there are already hundreds of gatekeeper entities involved with getting a company listed. You are basically investing in the idea that: ‘On average, these companies are run by people who want the company to succeed, and as long as the population of the world grows, and the middle class grows, this will make money’ Everyone could invest in index funds, and this would still be true, because if the stock price gets too low, it would be rational for the company to purchase its own stock on the cheap which would set the price floor.
bryananderson 6y ago
Obviously not “everyone” will ever invest in index funds. HFT firms, leveraged buyout folks, and prop traders at investment banks aren’t going to stop betting on individual securities. The people who have more information, quicker ability to act on information, or superior ability to analyze information shouldn’t buy index funds (they’re also the people who contribute meaningfully to price discovery). A smart individual retail investor is statistically unlikely to “beat” those people, and should buy index funds.
- mancerayder 6y ago
  I hear this over and over again. Beating the HFT firms, insiders, big money shops and so forth. It's not a zero sum game necessarily. A stock picker approach that you have as a retail investor that many trading shops do not have is this: time. You can make your bet, and if it fails in the short term you can hold onto the stock long term, unless the company is going bankrupt (which hasn't been a common occurrence up to now, given the overall number of stock symbols). Traders are individuals and groups with books, quarterly numbers to meet and yearly returns to care about. They'll beat you if you're a day trader, sure, but I think it's a false dichotomy to say, you're either a) a day trader or b) a boglehead.
  - throw0101a 6y ago
    > It's not a zero sum game necessarily. It is, actually. William F. Sharpe laid it out in the 1991 paper "The Arithmetic of Active Management": * https://web.stanford.edu/~wfsharpe/art/active/active.htm https://web.stanford.edu/~wfsharpe/art/active/active.htm * https://www.jstor.org/stable/4479386?seq=1 https://www.jstor.org/stable/4479386?seq=1 Sharpe won the 1990 Economics Nobel for other work: * https://en.wikipedia.org/wiki/William_F._Sharpe https://en.wikipedia.org/wiki/William_F._Sharpe The more active a trader is, over a longer time frame, the more likely they are to underperform the market. This has been shown through SPIVA over 15+ years, at least in the US and Canada: * https://www.tma-invest.com/spiva-data-reveals-15-years-of-active-underperformance/ https://www.tma-invest.com/spiva-data-reveals-15-years-of-ac... * 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... As of the end of 2019, internationally active managers didn't do too well either: * https://dividendstrategy.ca/what-is-spiva/ https://dividendstrategy.ca/what-is-spiva/ This has been known to varying degrees since at least the 1970s: * https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street
throw0101a 6y ago
> ISTM that the more people push on index funds, the more overvalued equities in the index become relative to those outside the index. What "index funds" are you referring to? The S&P 500? Dow Jones? NASDAQ 100? If you purchase a Russell 3000 index fund you are purchasing a piece in every publicly traded company in the US: * https://en.wikipedia.org/wiki/Russell_3000_Index https://en.wikipedia.org/wiki/Russell_3000_Index Any 'pricing irregularities' are discovered, then they will be pounced on any few remaining active investors. I recommend you read up on the following: > So what would happen if the majority of investors started to buy the market and stopped trying to beat the market? > Mispricings would start to develop regularly, and the people that had continued to try and pick stocks would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. Behavioral finance plays a huge role in market efficiency; nobody wants to accept being average by taking what the market gives them when there are hot shot managers that promise to consistently beat their benchmark. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market. * https://www.pwlcapital.com/the-grosman-stiglitz-paradox/ https://www.pwlcapital.com/the-grosman-stiglitz-paradox/ * https://en.wikipedia.org/wiki/Grossman-Stiglitz_Paradox https://en.wikipedia.org/wiki/Grossman-Stiglitz_Paradox
loopz 6y ago
currency != value
bluedevil2k 6y ago
While I don’t agree with your skepticism, there is a fund who goes off that theory that an S&P 500 index fund would become top weighted, or that the companies that have shown the most past growth are more heavily weighted, instead of focusing on future growth. It’s RSP, and it holds equal positions in all 500 companies equally.
gcb0 6y ago
You are correct in the analysis. But you missed the point that "it's a feature".
imtringued 6y ago
That's a pretty poor argument. What would happen in a world where everyone invested actively? People would switch to index funds to beat them. In your world people would switch to active investing to beat the index funds.
PascLeRasc 6y ago
Your argument is exactly what Michael Green talks about [1]. The talk I linked is from January of this year and he basically predicted the exact crash we saw in February. Individual stocks were going up and down tracking the S&P 500 exactly, based on no news or any kind of information, just that they were in the S&P index. The price of the stock did not reflect the company's financials or outlook. We're about to see this when Tesla gets added to the S&P 500 - funds will be required to purchase Tesla stock at any price. The reason that I'm personally an index fund skeptic is that I like to understand what I'm invested in. If you look through the S&P 500 members, there's dozens to hundreds of companies basically no one's ever heard of, and companies that I personally don't see a big future in. If index funds didn't exist, why would I take $100 of Fifth Third Bancorp or TechnipFMC when I could get $100 of Apple or Slack instead? The former is what you get when you invest in the S&P, while the latter are products I use everyday, and I feel that I understand how they make money. If you hang around investing subreddits long enough, it starts to feel like everyone's parroting the same 5 sentences about expense ratios and diversification, with no analysis or critical thought put into what the actual investments are. [1] https://youtu.be/x-rJciYZmi0 https://youtu.be/x-rJciYZmi0
- paulclinger 6y ago
  > If index funds didn't exist, why would I take $100 of Fifth Third Bancorp or TechnipFMC when I could get $100 of Apple or Slack instead? Because you don't know which one will become the next Apple or Slack and will invest before they are valued as the next Apple or Slack benefiting from all their growth. Some of them will die, but the effect on the overall holdings will be small given their small size.

branweb 6y ago

Not the op but I wish downvoters would comment giving their reasons. I remember seeing something about this in the atlantic a while back, and it would be good to know if/why it's a bad argument.

quotemstr 6y ago
There's this weird social energy surrounding index funds that's very aggressive about preaching that they're the only viable option and that everything else is ridiculous. To be honest, this energy is another input that increases my skepticism of the whole thing. These days, whenever you see an argument downvoted instead of rebutted, there's likely something to it.
- guenthert 6y ago
  I didn't downvote the earlier comment (and wouldn't as I'm quite clueless about financial matters), but felt the need to downvote another comment in an unrelated article recently. There I noticed, that once I applied the downvote, I couldn't see the comment being downvoted anymore. I meant to reply then to that comment on why I downvoted the comment, but couldn't anymore. I guess, that's the reason why one sees here so many downvotes by anonymous cowards.
- mancerayder 6y ago
  I think voting can mean different things to different people. Some people upvote or downvote because they agree or disagree. They view it as a "vote" for the opinion. Others upvote or downvote because they thing the argument is strong or weak, or maybe because someone said something nice and positive to another person or someone said something mean or hostile to another person. I strongly favor the second approach.
- hansjorg 6y ago
  Ever since Vanguard started there has been a constant barrage of anti index fund propaganda in the US. One of the early slurs was that index funds were communism (pretty daft, but probably effective in the US). The latest is this scaremongering "what if all investment were into index funds" (answered several times in this thread). From the perspective of index fund advocates, unsophisticated investors are systematically getting ripped off and the daft propaganda only adds to the offense. This is probably why you're picking up an aggressive preachy vibe from advocates. The empirical data is however unambiguous and there is now a lot of it.
- imtringued 6y ago
  Index funds allow amateurs to make money without losing it to "competent" active fund managers. That's all there is to it. You might not understand how many middlemen insert themselves between the amateurs because you're not one of them.
jdhn 6y ago
I bet skeptics would say that if you steer people away from index funds, then they may put it in high fee active index funds that generate about the same return as the passive index funds. Personally, I think that as more people put their money into index funds, active funds may look more attractive as they can potentially exploit market misprices quicker than passive funds can, but that's just me.
JulianWasTaken 6y ago
Not a downvoter (nor a financial expert) but to check the argument seems at least reasonable to check whether the proportional return of Vanguard funds has decreased as the fractional amount of money invested with them vs. the total stock market has increased. Seems unlikely the answer is yes (probably because in fact you are not investing in "nothing" -- there's value in having money itself, same as interest at a bank, and you are investing in giving that money to lots of companies, not just one, and that's what you're making profit off of. So long as money generates money, why should the return taper off?) Probably an interesting number itself knowing what the fractional amount of money flowing through Vanguard is as a proportion of the total.
- csmiller 6y ago
  By purchasing stock (not at ipo/sep), you aren’t giving money to companies, you are buying the share from another entity.

mensetmanusman 6y ago

Because there are already hundreds of gatekeeper entities involved with getting a company listed. You are basically investing in the idea that: ‘On average, these companies are run by people who want the company to succeed, and as long as the population of the world grows, and the middle class grows, this will make money’ Everyone could invest in index funds, and this would still be true, because if the stock price gets too low, it would be rational for the company to purchase its own stock on the cheap which would set the price floor.

bryananderson 6y ago

Obviously not “everyone” will ever invest in index funds. HFT firms, leveraged buyout folks, and prop traders at investment banks aren’t going to stop betting on individual securities. The people who have more information, quicker ability to act on information, or superior ability to analyze information shouldn’t buy index funds (they’re also the people who contribute meaningfully to price discovery). A smart individual retail investor is statistically unlikely to “beat” those people, and should buy index funds.

mancerayder 6y ago
I hear this over and over again. Beating the HFT firms, insiders, big money shops and so forth. It's not a zero sum game necessarily. A stock picker approach that you have as a retail investor that many trading shops do not have is this: time. You can make your bet, and if it fails in the short term you can hold onto the stock long term, unless the company is going bankrupt (which hasn't been a common occurrence up to now, given the overall number of stock symbols). Traders are individuals and groups with books, quarterly numbers to meet and yearly returns to care about. They'll beat you if you're a day trader, sure, but I think it's a false dichotomy to say, you're either a) a day trader or b) a boglehead.
- throw0101a 6y ago
  > It's not a zero sum game necessarily. It is, actually. William F. Sharpe laid it out in the 1991 paper "The Arithmetic of Active Management": * https://web.stanford.edu/~wfsharpe/art/active/active.htm https://web.stanford.edu/~wfsharpe/art/active/active.htm * https://www.jstor.org/stable/4479386?seq=1 https://www.jstor.org/stable/4479386?seq=1 Sharpe won the 1990 Economics Nobel for other work: * https://en.wikipedia.org/wiki/William_F._Sharpe https://en.wikipedia.org/wiki/William_F._Sharpe The more active a trader is, over a longer time frame, the more likely they are to underperform the market. This has been shown through SPIVA over 15+ years, at least in the US and Canada: * https://www.tma-invest.com/spiva-data-reveals-15-years-of-active-underperformance/ https://www.tma-invest.com/spiva-data-reveals-15-years-of-ac... * 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... As of the end of 2019, internationally active managers didn't do too well either: * https://dividendstrategy.ca/what-is-spiva/ https://dividendstrategy.ca/what-is-spiva/ This has been known to varying degrees since at least the 1970s: * https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street

throw0101a 6y ago

> ISTM that the more people push on index funds, the more overvalued equities in the index become relative to those outside the index. What "index funds" are you referring to? The S&P 500? Dow Jones? NASDAQ 100? If you purchase a Russell 3000 index fund you are purchasing a piece in every publicly traded company in the US: * https://en.wikipedia.org/wiki/Russell_3000_Index https://en.wikipedia.org/wiki/Russell_3000_Index Any 'pricing irregularities' are discovered, then they will be pounced on any few remaining active investors. I recommend you read up on the following: > So what would happen if the majority of investors started to buy the market and stopped trying to beat the market? > Mispricings would start to develop regularly, and the people that had continued to try and pick stocks would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. Behavioral finance plays a huge role in market efficiency; nobody wants to accept being average by taking what the market gives them when there are hot shot managers that promise to consistently beat their benchmark. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market. * https://www.pwlcapital.com/the-grosman-stiglitz-paradox/ https://www.pwlcapital.com/the-grosman-stiglitz-paradox/ * https://en.wikipedia.org/wiki/Grossman-Stiglitz_Paradox https://en.wikipedia.org/wiki/Grossman-Stiglitz_Paradox

loopz 6y ago

currency != value

bluedevil2k 6y ago

While I don’t agree with your skepticism, there is a fund who goes off that theory that an S&P 500 index fund would become top weighted, or that the companies that have shown the most past growth are more heavily weighted, instead of focusing on future growth. It’s RSP, and it holds equal positions in all 500 companies equally.

gcb0 6y ago

You are correct in the analysis. But you missed the point that "it's a feature".

imtringued 6y ago

That's a pretty poor argument. What would happen in a world where everyone invested actively? People would switch to index funds to beat them. In your world people would switch to active investing to beat the index funds.

PascLeRasc 6y ago

Your argument is exactly what Michael Green talks about [1]. The talk I linked is from January of this year and he basically predicted the exact crash we saw in February. Individual stocks were going up and down tracking the S&P 500 exactly, based on no news or any kind of information, just that they were in the S&P index. The price of the stock did not reflect the company's financials or outlook. We're about to see this when Tesla gets added to the S&P 500 - funds will be required to purchase Tesla stock at any price. The reason that I'm personally an index fund skeptic is that I like to understand what I'm invested in. If you look through the S&P 500 members, there's dozens to hundreds of companies basically no one's ever heard of, and companies that I personally don't see a big future in. If index funds didn't exist, why would I take $100 of Fifth Third Bancorp or TechnipFMC when I could get $100 of Apple or Slack instead? The former is what you get when you invest in the S&P, while the latter are products I use everyday, and I feel that I understand how they make money. If you hang around investing subreddits long enough, it starts to feel like everyone's parroting the same 5 sentences about expense ratios and diversification, with no analysis or critical thought put into what the actual investments are. [1] https://youtu.be/x-rJciYZmi0 https://youtu.be/x-rJciYZmi0

paulclinger 6y ago
> If index funds didn't exist, why would I take $100 of Fifth Third Bancorp or TechnipFMC when I could get $100 of Apple or Slack instead? Because you don't know which one will become the next Apple or Slack and will invest before they are valued as the next Apple or Slack benefiting from all their growth. Some of them will die, but the effect on the overall holdings will be small given their small size.