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> Thus the cap-weighted investment strategy becomes a self-fulfilling prophecy. Either you’re doing the math wrong or you’ve skipped some steps. Let’s say you

> Thus the cap-weighted investment strategy becomes a self-fulfilling prophecy. Either you’re doing the math wrong or you’ve skipped some steps. Let’s say you have companies X and Y, each with 50% of the market. X is a winner, and the stock price goes from $10 to $45. Y is a loser, and the stock price drops from $10 to $5. The new weight is X=90% and Y=10%. But this cannot be a self-fulfilling prophecy for index funds, because the index funds do not have to buy or sell any shares of X or Y to keep up (I mean rebalance, specifically). In this scenario, the index funds are just holding. (By “holding” I mean “not rebalancing”.) This is… an oversimplified scenario. But it illustrates the problem here with the “index funds cause a small number of stocks to be winners” theory. There are alternative theories that make sense, but not this one. (What makes the scenario more complicated is when you think of buybacks, dividends, delisting, etc.)

ethbr1 9mo ago
If new money is then invested into the index fund, it's effectively routed 90% to X and 10% to Y though, no?
- vkou 9mo ago
  The index fund's counterparty, which is selling the stocks is divesting 90% from X, and 10% from Y, though. There's always a counterparty to a trade.
  - ethbr1 9mo ago
    Obviously, but the point here is that cap-weighted index funds convert new money into buyers-at-any-price of their components. When they're more concentrated in specific holdings, and have enough new money, wouldn't that artificially support higher prices for those holdings (above what the market would otherwise bear)?
    - vkou 9mo ago
      Why not flip the argument, and say that the index fund is propping up stock B because of it's buy-at-any-price nature? What makes you think that valuing it at 10% of A isn't higher than what the market will actually bear? The sensible and consistent way to this is that... Index funds don't really have any effect on relative stock prices. If stock A is overvalued or undervalued, it's due to active investors being morons.

ethbr1 9mo ago

If new money is then invested into the index fund, it's effectively routed 90% to X and 10% to Y though, no?

vkou 9mo ago
The index fund's counterparty, which is selling the stocks is divesting 90% from X, and 10% from Y, though. There's always a counterparty to a trade.
- ethbr1 9mo ago
  Obviously, but the point here is that cap-weighted index funds convert new money into buyers-at-any-price of their components. When they're more concentrated in specific holdings, and have enough new money, wouldn't that artificially support higher prices for those holdings (above what the market would otherwise bear)?
  - vkou 9mo ago
    Why not flip the argument, and say that the index fund is propping up stock B because of it's buy-at-any-price nature? What makes you think that valuing it at 10% of A isn't higher than what the market will actually bear? The sensible and consistent way to this is that... Index funds don't really have any effect on relative stock prices. If stock A is overvalued or undervalued, it's due to active investors being morons.