A bigger problem with index funds is the inherent bias they create towards consolidation of capital at the top. A company that becomes part of the S&P 500 will automatically have bi-weekly buyers of their shares as people pump money into index funds via payroll deduction. Nearly every piece of mainstream financial advice in the US suggests such behavior... "d% of mutual funds fail outperform the S&P 500" etc. Of course such comparison ignores transaction costs, administrative costs, risk, diversification across asset classes, et al. However, it leads to many people who want to "Set it and forget it" to just buy the S&P 500 index companies automatically every 2 weeks, pumping up the values of large cap corporations whether they perform well or not.
I know that companies don't necessarily benefit directly from an increasing stock price, but in reality it allows them to raise capital by issuing new shares with less dilution. Also it makes it costlier for smaller competitors to raise capital, crowding out competition. At the end of the day, the "antitrust" question is not about Apple v. Microsoft... it is moving more in the direction of "Apple & Microsoft" vs. anyone trying to claw and scrape their way into the game.
It's precisely because of the administrative costs and transaction costs that the managed mutual funds are a bad idea: They don't outperform, in the long run, if just because their transaction costs.
That's really the point: An unsophisticated investor should go with index funds over the alternatives. To beat the market regularly, you need non-public information or insight, and the market is large enough that having said insight consistently is something limited to the highly connected.
Your argument against index funds, from a market perspective, is really more about putting all that money in large cap indices. Taking index funds to their conclusion, the ideal situation would be to use broader indices. Startups will still have to deal with venture capitalists, but that's for good reason: High risk, high reward investments aren't exactly what your typical index fund investor is interested in.
You make a good point, I really was only considering major large cap indices. I assume this is what most people mean when they talk about "index funds".
I'm not really against index funds per se, I actually think they are a great way to invest if you identify a trend in a particular sector. And truthfully, I'm far from a trained financial expert, I'm just some dumb hacker that is rubbed the wrong way by the type of advice I outlined in my above comment.
I'm rubbed wrong by the people who present at "Brown Bag Retirement Advice Lunch Talks" and want me to buy into their managed funds. The index funds have overhead in the range of .02-.5% for the most part. The managed funds are largely 1.5% and I've seen some that charge as much as 2.5%! I'll let you do the math, but it's very hard to choose a managed fund that will outperform after fees vs. S&P 500 from say Vanguard.
Most retirement accounts also don't allow individual stock purchases (at least mine doesn't), so the options are fairly limited for most people.
If you change jobs, one can always roll over 401k accounts to Individual Retirement Accounts instead of the next company's 401k program. At that point you can control your own retirement funds in the roll-over IRA. (As always check with your own tax advisers to see if that's a good idea for your specific situation).
There are indirect tax implications: Once you roll over your 401k into an IRA you can't use the Backdoor Roth IRA technique anymore (well, you still can, but then you would have to pay taxes).
Does it help to have a brokerage that has only 401k rollover IRAs and another brokerage that's used for backdoor roth? (I'm guessing not). I've been postponing a 401k rollover for the reason you state.
No. All of your pre-tax IRA accounts across all custodians are used when figuring out the taxes of the backdoor Roth. However, if you have a 401k at your current job that has good investments you may be able to roll your IRA into you 401k plan. That will clear out all the IRA assets to give you a $0 figure when performing the backdoor.
The problem with broader indexes is that they invest in stocks that are subject to less scrutiny (small caps / mid caps) so it creates a vector for a pump and dump. I'm not saying that the S&P 500 is the be all and end all of American index investing, but I wouldn't want the S&P 500k either.
It doesn't really work like that. Total Stock Market index funds are fine investments, which hold around 4000 US stocks. And since they are usually market-cap weighted, your exposure to each small-cap stock is small, so pump and dump isn't a real concern.
Yeah, you, and the people downvoting me, don't really understand what I'm saying.
Imagine I start a company and I get my friends to buy up the shares of it on the stock market. Now imagine the market cap is $10m the day before it joins the Russell 5000. The next day a seperate company goes bankrupt and my company is now 1/100000 of the Russell 5000, which means that ETFs that track that index are now buying roughly 20% of my stock, which raises the price to $15m. Next my friends can slowly sell out for the amount that they pumped, but they will never trigger a mass sell off, because I always had a controlling stake from the beginning.
I would argue that the impact of these "buy and hold" investors on share price is minimal. There's so much liquidity these days that any one class of investor should have a minimal impact on the share price. The index funds end up moving WITH the market, so any downward (or upward) trend will be followed by whatever balancing algorithm they use.
Your big swings in share price are still going to be driven by HFT algo traders, activist investors, hedge funds, etc.
I do agree that companies in the S&P 500 have an oversized advantage in raising capital, but if you remove index funds from the picture, I think the mere existence of the index would have a similar effect (this could be researched historically, but I don't have the time/interest to do so). On the flip side, any stock in the S&P is going to have limited arbitrage opportunity due to the level of liquidity they get from index fund rebalancing, etc.; so algo traders looking at specific plays may want to find an asset with lower liquidity and fewer eyes watching it. As with anything in finance, there is a play available on both sides of the field and they tend to balance each other out.
HFT affect and take advantage of minor price swings[2], and their arbitrage is based on this. Long-term investments are the primary driver of (hence) long-term price movements. After all, HFT, by definition, have no long term interests in issues, so they are (usually) equally weighted in either (long or short) direction, thus cancelling their long-term effects out, even in a situation where there are no long-term investors.
1. This pertains your comment regarding HFT. Activist investors, which you also mentioned, are just long-term investors with a marketing strategy (put your money into something and then go tell everyone), and in some cases a lobbying strategy (e.g., Bill Ackman's notable short of HLF), and they have no place being compared with HFT.
2. It is true that, sometimes, minor price swings can cause a crossing of a tipping point (e.g., below a prior price support level, etc.), but even in these cases the long-term price will adjust for these swings based on intrinsic value.
I was more referring to the liquidity provided by HFTs -- they do tend to speed up price corrections, even if they're not the primary driver. I was referring more to the tipping point scenario -- HFT ensures that asset bubbles don't persist for long.
Good point. Actually there is a thriving segment of the broker and hedge fund market whose entire game is figuring out which stocks will have their weights changed at each new index rebalancing, and "front-running" the index funds who can't do anything until it becomes official. Thus they profit off what is a market inefficiency, scraping value from the passive guys, which in the long run could I suppose limit the index fund phenomenon (though not the indices themselves).
Essentially, if the "front-runners" (not really a correct term, since nothing illegal is going on) weren't doing this, then the index funds would have to pay a huge premium to buy large amounts of stock on extremely short notice. The "front-runners" are actually reducing the index fund's overhead costs (and, yes, being compensated by the market for doing it). They certainly aren't cheating the index fund investors out of anything, because their investments will track the market, regardless.
The "front-running" we're talking about isn't really a huge problem. It's a relatively limited arbitrage opportunity, and the ETF fund runners can just start performing this sort of arbitrage themselves if it becomes too big of a problem. I'm guessing insurance against this kind of activity is already priced into the fees of most ETFs (so yeah, they're scraping value, but not a lot and there's not a lot of opportunity for expanding it).
They absolutely should be doing that, but this market inefficiency is strangely persistent. In the bond world at least, I have watched hundreds of billions under management by sleepy fund managers in Europe who operate like bureaucrats for years: all they want is to be fed the index rebalancing weights each month and they don't take much notice of the value being left on the table by not anticipating changes efficiently. Perhaps its because the industry is biased towards fees rather than performance that this persists, but I don't have a great explanation for it.
I know for sure though that there are fast-money guys who obsess daily about weighting momentum and turning points and they do well quite consistently.
Yeah, I think that's exactly what OP was saying. When a fund says "we beat the S&P index fund by 5%", the actual returns to the individual may be very close to what you get from an index fund. After fees are taken into account, few mutual funds (or hedge funds for that matter) can beat an ETF on a consistent basis.
Mutual funds have their place (large, pooled plans like 401ks where there's enough money involved that fees can be negotiated come to mind); but they're probably not the best option for an individual investor. I always recommend newbie investors put most of their equity holdings in an S&P ETF for this reason; the returns on a mutual fund may be slightly higher in good years, but they'll almost always be worse in bad years.
I'm very much not an expert, but wouldn't something more diversified than S&P be better? Isn't that the one free lunch?
My money (as a student that's not much) is invested in a fund that tracks the MSCI All Country World Index, which was the most diversified Index fund I could find.
Yes, a more global approach is technically more diversified, but you have to make sure the fund's holdings match the name on the tin (and that the expense ratio isn't too high).
I wouldn't call it a free lunch though. Very much the opposite. You're investing in the global market portfolio in order to avoid a potentially costly lunch (i.e. fees, trading costs, not keeping up with the market return, etc... I've stretched this analogy too far, I know)
Depends on how larger company stocks are doing relative to a broader slice of the market. Same for US vs. various international indexes. Even if you're diversified in a number of different index funds, that doesn't mean you should necessarily be "forced" to invest, for example, in areas of the world that seem to have systemic issues (at least with respect to stock market performance).
With respect to US equities, the S&P 500 and the Russell 4000 have performed fairly similarly over the past 5 years; which has performed better depends on the time period you look at. The NASDAQ has been a little bit higher overall but, of course, it also had a bigger drop if you look at a longer horizon.
The theory is that all known pros and cons are priced in; unless you're a big enough player to move the market, investing a dollar in any one company is as good as investing in any other. This assumes a perfect market and is therefore pretty dumb, but the guys that move the prices are probably better at pricing risk and upside than I am, so I can't take advantage of the gap between theory and practice anyway.
The upside of diversification is that your return simply get closer to the mean as opposed to varying wildly as it would if invested in a single company's stock. You basically get increased predictability at no cost.
Not necessarily -- nearly every company in the S&P is a globally diversified mega-corporation, so you still get global diversification as a result of many of the companies themselves being diversified.
Also, by all accounts the US (and specifically New York) is the financial center of the world. This is why the IRS has such immense power -- they can come after anyone, anywhere because a global bank simply cannot operate without a good relationship with US regulators.
> Yeah, I think that's exactly what OP was saying.
No, it's definitely not. OP thinks that the argument for index funds "ignores transaction costs" when that's pretty much the entire crux of the argument: if a mutual fund won't do much better than an index fund, you should go with an index fund as it has substantially less costs.
Seems like other market participants (hedge funds, individual investors) are providing a solution to this problem by analyzing inflows and outflows into such index funds and creating respective positions in case they think an index is over-bought or over-sold.
>Of course such comparison ignores transaction costs, administrative costs, risk, diversification across asset classes, et al.
That's exactly why mutual funds underperform. Given the EMH, it makes more sense not to spend so much time on 'asset management' like that.
If you believe the S&P is overvalued because too many people index to it, you can invest in broader index funds and, if you're correct, yield a higher return.
Your theory directly contradicts the Efficient Market Hypothesis. If "dumb money" is flowing in to large cap funds, institutional investors should be able to take advantage.
Then it should be very easy to make money by buying S&P501+ and shorting the S&P500. If you believe the theory in the OP, you can bet on it (and against EMH) by doing this.
The question is: how much are you willing to bet on it?
P.S. In case you are wondering, I have bet a significant amount of money on the EMH being correct.
Also I'm not saying that the phenomenon in my above comment is something would be an efficient use of money to trade. Personally I'd much rather look at out-of-favor sectors like commodities than try to pick up pennies in front of a steamroller by attempting to arbitrage the S&P 500 and S&P 501+ (as you put it)
In any case, thanks for your comment it does give some important food for thought
I have no interest in the hubris of shorting into a raging bull market,
Read what he wrote: he stated that if you believe what you wrote, you can collect the spread by shorting side you claim underperforms, and going long on the side you claim outperforms.
If what you said is true, it's extraordinarily low-risk arbitrage.
If what you said is false, you're best served to say a bunch of bullshit that 's unrelated and then not make the trade.
Shorting exposes you to potentially unlimited losses and you might have to keep putting up money to stay in your position if the market turns against your short position (even if the other side of your trade is working). You'd have to be very sure about your timing or have unlimited funds/credit in order to use that strategy. And even if you made money doing that, it doesn't mean that there isn't a better opportunity elsewhere in the market, risk adjusted or otherwise.
But if it makes you feel good to swear at strangers on the internet, you can sign up for anonymous accounts and say I'm full of shit, and I'll be glad that I could help boost your self esteem.
Bcg1 is not an ideal investor. He does not have an unlimited line of credit at top tier interest rate. Shorting S&P500 would be very dangerous for him.
A better strategy would be to underweight S&P500, and overweight the companies that are the closest to being included.
What you are describing is a lower-risk strategy, but it has a lower payoff as well. If one is very sure that a stock is overvalued, shorting is the best (simple) strategy to profit from it; if one is less certain, your strategy is a good one.
What if you are very sure that a stock is overvalued, but totally unsure where it will peak first? Shorting it could leave you in real trouble then, even if you can somehow be totally certain that you're right about where the price will eventually be.
I was talking about the S&P500, which is composed of a few hundred different companies, so the risk of one company hurting you is low. You are right about the risk of shorting, but it is the strongest bet you can make. I would probably take out a put option on an S&P500 ETF if I agreed with the post I initially responded to. By buying the S&P501-750, you would also be fairly well secured against market upside risk.
My first response was intended more as a rhetorical question asking whether the poster is actually willing to bet money on their idea. I never really meant to enter into a discussion on the pros and cons of various trading strategies.
Even the S&P 500 could keep on going up a long way despite eventually being doomed to drop substantially. (I have no idea if it actually is, of course.)
My point is just that seeing if someone is putting money behind their opinions about the long term isn't really telling, because "markets can remain irrational longer than you can remain solvent" and you may not know just how long term it'll be.
In addition to the margin call concern, just because a stock is overvalued doesn't mean it will reach its fair value before an adverse event (let's say the company makes a gamble with positive expectation, but it doesn't work out) happens that lowers its fair value. If that were to happen, he could be a few hundreds of millions in debt.
>"In addition to the margin call concern, just because a stock is overvalued doesn't mean it will reach its fair value before an adverse event (let's say the company makes a gamble with positive expectation, but it doesn't work out) happens that lowers its fair value. "
I'll assume that you meant the opposite of this quote (, that the stocks being short-sold beat expectations, and their fair value went up,) as what you said would benefit the short seller.
You are right that the stock could take longer than expected to reach its eventual (lower) value, but this is why you would bet on a large number of stocks (i.e. S&P500), to reduce the risk of a single or few adverse events cancelling out the strategy. In addition, by purchasing the S&P501-750, with the money from short-selling, you would be fairly well protected against market upside risk (as it is unlikely that the S&P500 will be the only stocks to do well in a bull market). You could also purchase options to reduce the risk of the short, but a (simpler) alternative would be to take out a put option on the S&P500, which the better believes will go down; this is obviously somewhere between the portfolio bias approach, and the short approach in terms of risk (and reward if you believe in EMH).
People like Warren Buffett and Jim Rogers would end up being the enforcement mechanism behind what's being proposed. Value guys are all about taking advantage of undervalued stocks, and companies that just barely miss being in the S&P 500 are still big enough to have a lot of eyes looking at them investigating whether or not that might be the case.
In light of that, I find it very hard to believe that a huge valuation discontinuity right between company # 500 and company # 501 is likely to stand for long.
Which isn't to say that I necessarily think the EMH is correct, but I do think even if EMH is incorrect there's still plenty of reason to believe that any major market distortion created by something as obvious as the popularity of index funds is unlikely to stand for long.
Not that I disagree with you (although I think you may have misinterpreted EMH) but your argument is structurally identical to saying, "What if the odds of winning the lottery aren't so long after all? Lottery winners might beg to differ!"
You could be right, but I don't consider investing to be the same as the lottery. Buffett and Rogers consistently beat the market, year after year, decade after decade.
The Quantum Fund (started by Jim Rogers and George Soros) had a 3365% return in the 70's, while the S&P 500 returned 47% (http://www.streetstories.com/James_Rogers.htm). Rogers also bet against Black Monday in 1987, wrote about the housing bubble and 2008 financial crisis as early as 2004 in his book "Hot Commodities", and called the collapse of the gold price in 2012 as well as the recent epic dollar rally.
You could be right and my understanding of EMH might be off base... but if all information was "priced in" I can't understand how such individuals could consistently be "right" when the broader market is "wrong".
Yes, it's strange that people think stock market investing is purely a game of chance. The reasoning is typically "A winning strategy would be universally communicated, adopted, executed, and priced out." Which is a strange way to think.
Go is a popular strategy game. Strategies that work should be encoded into computer algorithms and "priced out". Yet computers can't beat the best human Go players. Are the best human Go players simply lucky: they have no true strategy, and it's chance when they win?
(Hint: not every strategy is easily encoded into a deterministic algorithm. Expert human insight and judgment, that finicky beast, is not yet replicable by machines.)
Exactly. And being a threshold, it also should be concentrated at the margin, where companies "just outside" the S&P500 should see some measurable benefit vs. the ones "just inside" the list. I'm not aware of any such analysis.
Yet another addition to my list of Matthew Effect examples and how this effect may be enemy number one, undermining entirely the notion that an unregulated free market produces a level-playing field and a meritocracy.
2) Nobody -ever- has said that an 'unregulated free market produces a level playing field and a meritocracy'
The facts are that a regulated and controlled market with freedom of economic action produces the best outcomes for a population as a whole, when measured in life expectancy, social mobility and and even environmental cleanliness. Every other system that has been tried produces far worse outcomes across all these measures.
There's a persistent adolescent thought pattern running these days which says something like 'free market? Huh? Where's my lamborghini? I got nuthin' but student debt and no job'
This kind of thinking should be avoided in order to make progress on the topic.
Then just buy the index fund. I can buy an index fund that has fees of 0.2%. If the managed fund has fees of 1.2% that means it needs to beat the index by at least 1% to come out even. If you can beat an index by 1% while trying to replicate an index, then you're either a genius or cheating.
The numbers are even worse if it's in a taxable account. That means you need to beat both the management fee and the taxes because you'll end up paying taxes for all the turnover too.
Well the idea is to beat the indexes on a net basis. The fees would be much lower (than 1.2%) because it would not be very active. It would be replicating the index (which lots of people can do fairly easily) but with a tweak or 2 like a slight change in weighting or trimming the 50 worst X or lopping off the 10 biggest caps. I've seen some back-testing on stuff like this that can get you that extra point or 2.
Interesting. The idea is that index funds implicitly favor collusion between companies in the same industry since investors/institutions own the competing companies (perhaps even at the same weight). That is, an index owning both Coke and Pepsi may not be too keen on one slaying the other, but instead for them both to become bigger together, yet separate.
There's also the idea that index investing "should" be considered illegal because of the possible antitrust issues.
Also, the rise of index investing puts more favor to stock buybacks/dividends as opposed to reinvestment. The idea being (as an example) that the index would rather take Coke's profits and redirect to a smaller higher-growth-potential company (or even spread it out more evenly among all holdings). However, if no index investing, perhaps investors would be more willing to "ride it out" with Coke reinvesting a lot more profits back into the business (maybe the don't own Pepsi, or other soft-drink companies and want to see them all get demolished).
An index owning both Coke and Pepsi wants the soft-drink market to grow bigger -- it is presumably indifferent to whether Coke slays Pepsi, Pepsi slays Coke, or both grow bigger together, as long as the total market increases.
Which is arguably a good thing. Let's say that Coke has 60% of the market and Pepsi has 40% of the market. If Coke's investors are separate from Pepsi's investors, then it would be in their interests to take a tactic that kills Pepsi and allocates half of its market share to Coke and the other half goes up in smoke to a smaller overall market -- now Coke is half again as big as it was! But the industry is smaller.
That said, I'm not sure that realistically, market-decreasing tactics really exist in most cases -- I can't think of a real world example.
More precisely, an index fund owning both Coke and Pepsi wants profits from the soft-drink market to grow bigger, and the easiest way for that to happen is for both companies to increase their prices at the same time. Note that this is exactly the opposite of how competition in capitalism is meant to work - it's meant to drive down prices towards the cost of production, increasing overall efficiency as it does. Note also that this likely also results in selling less soft drinks than if the companies were actually competing, because increasing prices generally decreases sales.
Coke and Pepsi don't compete only with themselves, they compete for a "share of stomach" with a huge number of other drinks and foods. Rising prices for soft drinks can drive people to those other drinks, eventually eroding profits.
However those "other drinks and foods" are also owned by Kraft, Altria, Nestle, and FritoLay, which are in turned owned by the same index investors, so we've just pushed our antitrust argument up one level of metaness.
Yes, I know some of these have probably bought others of these, I'm not up on food industry M&A
It's way more complex than that. Coke and Pepsi compete with tap water, owned by the local utility, as well as fruits and even the local snack stand, since sometimes people have enough money to buy a coke OR a snack, but not both.
In other words, it is far too complex. In Brazil, for example, a major competitor of Pepsi and Coke on the at-home segment if fruit sellers on traffic lights. People can buy a bag of oranges for a buck or so, and make a lot of healthy juice out of it, instead of spending 5X for a sugary drink.
And if there's opportunity to invest in companies which are undervalued due to being out of indexes, believe me, there will be plenty of people doing it.
Generally, executives get compensated in stock in some way in their company. So the Coke C-Suite is motivated to compete with the Pepsi C-Suite even if the board members are the same for both companies.
I think it is a problem. Unless you've worked in one of these industries where there are a handful of major players and rough parity of capability between them (like consumables, electronics manufacturing, heavy industry, oil & gas), corporations trade execs on a regular basis, and when those execs jump ship for a competitor they often lure away a good number of their key staff, too. So not only do you end up with a bigger overall market if they all do well, you end up with leadership (both executive staff and board members) who knows the ins & outs of everyone. It is in everyone's best interest for everyone to succeed, but if a company falters significantly it becomes either an acquisition target or it slowly fades away as key talent migrate to competitors.
Not only this, but if you attend the earnings calls for corporations in the same sector (or even better, if you're lucky enough to attend one of their investor & analyst days), you'll see firsthand how the analysts are wined & dined, and how closely everyone knows everybody else. It's a big game that creates a ton of wealth at the top -- as long as the status quo is roughly maintained and change is incremental.
I understand what you meant, but wealth being created at the top is a bit charitable. Let's call it like it is: it's reallocated from consumers (vs. a more competitive market) and from shareholders (vs. a more competitive management landscape).
Regulatory capture should have a management capture analog. ;)
> That said, I'm not sure that realistically, market-decreasing tactics really exist in most cases -- I can't think of a real world example.
What do you mean? Of the Coke/Pepsi type market? Giants whacking away at each other?
If you are looking more broadly - the 'market decreasing tactics' is one aspect of what the innovator's dilemma is about. One of my favorite VC types, likes to invest in companies that fill the following thesis: "AcmeCo is a new entrant, with some cool tools, into an aging $50B (or whatever) / year industry. When AcmeCo is done lighting a neutron bomb in the industry and the dust settles, it is now a $5B industry, and AcmeCo is the last man standing with 60%+ market share."
> The collusion argument is certainly interesting.
That it is. I had not come across some of the structure of the argumentation in this article before.
Because both companies are on the index that the index fund matches, and the whole premise behind index funds is that they're set up to require their managers to purchase stock of all companies in the index (managers not allowed to pick and choose).
Because then it's not an index fund, it's an actively managed fund.
The appeal of an index fund is that it mechanically tracks an index so costs are very very low and investors can track the market as closely as possible.
The idea of an index fund is that you neither buy nor sell. Just by sitting on your stock, you get average returns. There are a few exceptions: when someone invests in the fund, the fund has to invest their money, and vice versa when someone withdraws money from the fund.
When a company enters/leaves the index the fund is tracking, the fund has to buy/sell their shares.
In other words, there's no "silver bullet", no matter the industry. I also think that we should stop believing in the "wonder" of compound interest and act accordingly, because it will come a time when this "wonder" will prove to be just that: a thing that cannot last forever. The same goes for a guaranteed rate of return on investment.
Seriously. Sometimes I wonder about who actually is visiting this site.
The 'wonder' of compounding interest?
It's merely the monetary representation of the return on investment in productive activities and assets. The reason money has a cost is because it can be converted into useful, productive activities, so the holder needs to be compensated for that.
The 'wonder' is how animal herds and horticulural products increase enough in quantity to feed us all.
Building a shelter over your head is compounding interest at work. You sleep better, stay healthier and have more time to do other things. Same goes for a knife or a spear, or a factory or a computer.
I find it incredibly odd that we have people running around saying 'we have to stop growth' 'growth is bad'. Yet, on all measurable criteria - every single one of them - things keep getting better. This is because of the compouding effect of investment in knowledge and productive capacity.
I'm not sure where the growth-hate comes from, if it is ignorance or just some sort of strange moral fashion to hate on the modern world. Either way, a class of people have convinced themselves that - of the entire trajectory of growth from nomadic paleoithic peoples to now - it's right at this point the wheels are about to fall off. Strikes me as a little narcissistic, really.
> Seriously. Sometimes I wonder about who actually is visiting this site.
I'm a programmer who sometimes reads about economics and economics history. I've also worked in some finance-related industry for a couple of years early in my career (in the IT department).
> This is because of the compouding effect of investment in knowledge and productive capacity.
Yes, I know how compound interest presently works, I was just questioning its long-term (think 50-to-100 years, if not more) viability. To give an example which I stole from people smarter than me, just think that if you had invested your pension money on the Russian stock market in the 1910s or on the Chinese stock market in the 1930s you would most probably be bust (to say nothing of nationalizations and confiscations of private real estate). And these are two pretty big examples which happened in the last 100 years.
The idea that the return on the rate on investment on the long term can only go down I've stolen from Jean-Baptiste Say, who wrote it down in the ~1820s. Now, he just happened to write this before the Industrial Revolution started doing its thing and, just as important, before economic colonialism started to positively influence the Western economies of that time (think the Opium Wars). Now, you're saying that we'll be able to somehow reproduce that Industrial Revolution a second time, I question that optimism.
> I'm not sure where the growth-hate comes from
I'm not at all "hating growth" (even though I believe that we should be well aware of its downsides). I'm just saying that it's no good making only positive economic projections about the future, we're not magicians and crystal balls are just that, pieces of glass.
If your here to quote Says law then you have my support. But while growth in specific investments must always stop, eventually, aggregate growth will continue unless people opt for a lower standard of living.
It's easy to look at a particular assets class - say railways- and show zero return over a long period. But looking at all improvements across all industries shows growth is always coming from breakthroughs somewhere. Healthcare, rocket science, these are two major fields wher rapid change is evident, even if it is of the incremental kind.
I think you've mixed up the concept of compounding interest and specific assets classes ability to return positive and withstand time. They are really two separate topics.
Capital could never be directly translated into power. Capital always had to be used to buy enough people who combined had power. Those people could refuse to be bought and instead join those without capital on moral reasons. Even as technology allowed us to use capital to increase the power of a small group of people, there still had to be a small group of people.
But we are soon to hit a point where capital will be used to buy power directly thanks to advances in AI and robotics. We may never again have another cycle like you describe.
To be honest, I fear this, because I consider it likely enough to fear, but I don't think it's the most likely outcome by a big margin.
If you want to know the probable outcome of an Intelligent Capital vs. The People fight, just look how a big company defends its computer network against targeted hackers today.
I think the point the parent is getting at is that nothing about business guarantees constant, compounding growth. It's not just mathematics, it's population growth, productivity, capital distribution, etc. - lots of stuff that we take for granted that results in constant growth rates, but that doesn't necessarily have to.
Compounding interest could continue at the upper right part of the S-surve. If the interest decreases every year, and sufficiently fast, it could give rise to a convergent infinite product. So total wealth would never exceed the threshold of the possible.
As far as I've read "index tracking" is seen as this wonderful thing that cannot go wrong. Until it does. It's another way of saying "this time is different".
The last part of my comment is related to the fact that "index tracking" and all the related "investment strategies" rely on the assumption that, over all, things will only go up, i.e. ROI will always be positive. I questioned that assumption. We cannot guarantee that in 30 years' time (let's say) we will still be able to return 3-5% on our huge piles of pension funds' money, no matter the strategy. What I'm saying is that we should be prepared for a stagnating or even deflationary world, financially and economically speaking
It's almost entirely about paying less in fund fees and aiming to be 'average'. I.E. get the return of the market rather than trying to beat it. Think of it as 'passive' investing rather than index investing.
EDIT: But yes, we don't know whether one can assume "The S&P500 will average 10% per year for EVARRRRR!!!1".
I'm not the OP or the grandparent post, but I wonder what happens if a significant portion of the market starts indexing? My gut is that there are strong incentives against that: as more people start indexing, the gains from not indexing become more diverse.
You realize that the scenario you describe is equivalent to "the entire collapse of global civilization that will make previous dark ages look like candy and unicorns."
I'm serious. If the overall economy is "stagnating or even deflationary" for any significant period of time, all of the wheels are going to come off.
(Really want a dark thought? You realize that we've dug up and used all of the easily-available oil, right? When Some Later Generation Gets Its Act Together, they aren't going to have a convenient, cheap source of energy.)
Yes, parent poster said that index funds "seen as this wonderful thing that cannot go wrong." But nobody who knows anything about investing sees them that way. Index funds invest in stocks and bonds, a broad index fund will pretty much mirror the market. But the market, even the market as a whole, is far from safe.
What an index fund does guarantee is that holders of the fund will do better than the average of the "active" investors, who try to pick and choose the best stocks in the index (which for a broad index is basically "the market"). This is because the active investors, as a whole, receive the "market return", but they do so only after investing resources in researching the companies (which index funds don't do) and because the active investors trade a lot, relative to the index fund, so the active investors incur much greater transaction costs. An index gets the market return, but without incurring the costs active investors do, so the index is certain to have a better net return than the average of all active investors. This doesn't mean that index funds are "a wonderful thing that can never go wrong". It's certainly possible for the market to tank, in which case it's little solace for index fund holders that they beat the performance of the average active investor.
> (Really want a dark thought? You realize that we've dug up and used all of the easily-available oil, right? When Some Later Generation Gets Its Act Together, they aren't going to have a convenient, cheap source of energy.)
Plenty of nuclear fuel still around, on earth (uranium, thorium, hydrogen) and in the sun (solar power, wind, etc).
Digitized data is replacing physical storage, and that makes it ephemeral.
How would you read a DVD without a player? Can you rebuild the player, without specs? Can you rebuild the filesystem, or the decoding?
There is plenty of cheap energy that isn't oil--unfortunately, the exploitation of it without oil reserves to bootstrap with may prove impossible. That's the point being made here.
I would argue that while information can't die, expertise and built up production capacity certainly can, and I think that's even more important. I could read all the books I wanted about how to build a plane, but I highly doubt that I'd have the first clue where to start.
Medieval villages didn't use oil either. Have to get past that point. Have some oil-seed crop, sufficient population, trade with large cities. Then - buy antique samples of thorium and uranium, put in a pot - they melt and give off heat. Not too complicated really.
Like @kspaans says it's more about buying a representation of the market i.e. passive investing. Though, in the case of the S&P500, 500 large cap US stocks is hardly buying the market, so a keen investor would try to create a truly diversified portfolio including domestic, international, equities, bonds, real estate, commodities, etc.
The quote "stock acquisitions that create such anticompetitive horizontal shareholdings are illegal under current antitrust law" doesn't seem to include any reference that I can find to any original text written by Elhauge. Instead the footnote links to a bunch of the author's own articles about Elhauge.
The only properly cited textual evidence offered is a series of denials by Elhauge that he ever said index funds are illegal.
It seems like Levine has an axe to grind with regulators, and doesn't want anyone to talk about research that might suggest regulation. He might be right, but he is making a crappy argument.
EDIT: Ok, I stand corrected. Elhauge totally said that. It's in the abstract. I had trouble finding it because Levine cited himself instead of the paper at the end of that that paragraph. Sorry.
Interesting. With enough optimisation of the mechanisms of modern capitalism we arrive at a state where a single amorphous entity owns the economy so there are no incentives created by competition.
Isn't the whole capitalism based on promising people monopoly but not letting them actually get it? I.e. no profit-seeking entrepreneur in their right mind would act to create competition for themselves. Competition means waste of time and resources, so there's no surprise every player tries to figure a way how to reduce it, aiming for bigger and bigger pieces of the whole pie in the process. The state you described seems like a part of the natural evolution of market incentives.
> Isn't the whole capitalism based on promising people monopoly but not letting them actually get it?
No. Modern mixed economies, which have replaced capitalism as the dominant system of the developed world since capitalism was described in the 19th Century, are based on incorporating the features of capitalism that tend toward monopoly, but incorporating other features to impair the development of some monopolies and restrict the adverse impacts of other monopolies.
Capitalism itself does nothing to control monopolies.
As long as the ability to create competition is preserved natural monopolies aren't really sustainable except in controlled markets with limited resources (utilities, airwaves, cable, roads, etc).
As much influence as Google has on internet searches, they could relatively easily be displaced by something better and worth moving to, for example. I've tried DDG, Bing and others, and their products aren't really better, so Google it is. When there are actual consumer costs involved, this becomes a bit more flexible...
As an example, unlike "Demolition Man" I can't really conceive of any chain/restaurant actually controlling all of them, so long as allowing for competition is ensured... However, given ever increasing interpretations of IP protection, I could see the likes of ConAgra actually becoming a controlling factor in all restaurants, more than it already is. This is a case where protectionism is counter to a free market though. IP protections are supposed to be "limited" but are increasingly less so, which makes things worse for society.
Nobody really wants true anarchy, but we've been headed towards so many constraints, that I wouldn't call what we have in corporatism anything resembling free market capitalism, even with natural monopolies.
If you define capitalism as "property laws allowing ownership of capital" and further define it as "laissez-faire" meaning that the state does not use its power to promote or restrict particular firms or outcomes, then at the very least you will get the promotion of competition between industries, plus eventual limits to what a firm can do.
For example, if a monopoly in airlines leads to prohibitively expensive plane tickets, then competition from bus lines will serve as a control, and the monopoly for "all transportation types" will be reduced. Unless of course you have the airlines buying out the bus lines. But even in that case, there is a limit to how much they can charge because a new firm can enter and make a new capital investment in that industry. So at most, the monopolist can charge whatever rate would make it prohibitively expensive to enter that industry.
I can see several strategies you could use under conditions you described to maintain your monopoly if you're already big. You could, for instance, immediately buy out any serious competition before it becomes dangerous. Or, since you're a big player with deep coffers, upon seeing an upstart you could start operating at a loss an just wait until your competitor runs out of capital, and then bring the prices back up. Defeating you would require a lot of people coordinating to hit you at the same time, and we all know that people suck at coordination (and if somehow they managed to orchestrate such an operation, it wouldn't take much to bribe a participant and turn him into a defector in order to derail the whole group).
Or you could just hire a hitman. There's no concept of "fair play" in the "physical order of nature".
No, not always possible, but it is very much so the rule, rather than the exception. The many wonders of the modern world are, by and large, the result of capitalist forces.
Article thesis is that funds go around that limit. Not even on purpose, just by their definition. No single company has monopoly but index funds collectively own all of them.
The article also explains that this is only true when a few large players control the market. E.g. an index that includes all of the major pharmaceutical companies. Indexes generally don't invest in startups taking on the incumbents, so there's an opportunity there as long as competition is realistic / the existing players are not too entrenched.
Yes, exactly. The former are incredibly rare, and the latter are common as muck.
For all the pearl-clutching that goes on about monopolies, you'd think people would twig onto the risks in letting the size of the government grow to such a point where granting favoured friends monopolies is not only possible, but simple to do.
Actual monopolies in real fields are very rare and very fleeting due to competition in the same product lines or substitutes. A monopoly is very difficult to hold without the use of force, and governments are the only legalised users of force.
It is usually a waste of resources to try and break up what are seen as 'monopolies'.
That is true if you limit yourself to preserving some political structure. It is not true if you consider revolutions and radical changes to be politically legitimate. There is no ideology or system you can encode in prescriptive rules that endures forever. Capitalism(s) has had a long run, but so did feudalism(s). I pluralize because those systems have changed. What happened to feudalism in the end was that its fundamental tenets were overthrown. What remained could not be called feudalism. It remains to be seen if and how that occurs with capitalism. What can be discarded to make the incumbent institutions endure? How long will that last?
I have only seen recent studies finding that campaign spending has little impact on electoral outcomes; if you have evidence that elections can be bought, please provide it, so that I may be enlightened.[1]
TLDR: authors designed and performed some actual experiments whose outcomes support the thesis that campaign spending works - better for a challenger than for an incumbent.
I don't see any risk of this scenario. I invest heavily in index funds. Generally my focus is on which countries / regions I believe will outperform others. It has provided strong returns without active trading.
This is cool, but incomplete. An index fund would still want competition if by competing, Pepsi gains 100% and Coke loses 1%. i.e., in any case where competition grows the pie rather than cuts it up differently, the index fund would want competition.
I claim this is the right result. We should discourage competition where everyone ends off worse, and encourage competition otherwise. Individuals competing do things like dump goods below cost to bankrupt smaller competitors; an index would perhaps not do that.
Well, consumers shouldn't be much worse off, otherwise it creates an arbitrage opportunity.
Although Pepsi and Coke may be indexed, they aren't the same entity allowing investors to just own one. If there's some action that Pepsi could take that would massively reallocate the pie in it's favor (by winning over consumer for instance), then investors ought to start massing to it and becoming more activist. This would come at the expense of the index of course.
So really as long as there's easy 'severability' of the companies in the index, they shouldn't be overtly monopolistic.
But I agree in industries with high capital requirements (energy, biotech, etc.) it may be impossible to separate out the companies and then they would be de facto merged.
This really is an interesting idea because a solution seems hard to find. Outright banning indexing would be nearly impossible to enforce (large pension funds could reproduce the index at a slighter higher cost).
I agree with you, but the article is making a pretty strong argument that indexing discourages competition in a way that makes everyone worse off.
"[Elhauge:] 'Fourth, if index funds alone would create a problem of anticompetitive horizontal shareholding in a concentrated market, and those index funds feel the benefits of diversification across all firms in that market exceed the benefits of influencing corporate governance, they could commit not to communicate with management or vote their shares.'"
I believe that is the case now: index funds don't vote or attempt to influence management (at least I've never heard of it). Also, each individual fund is limited in the proportion of an individual company it can own, but that limit does not apply to the total sum of index funds.
"If you think that institutional investors are causing managers to stop competing, there are more plausible mechanisms for that than voting. Just leaving managers alone, for instance, probably itself tends toward anti-competitiveness: If shareholders don't pester management, they will probably compete less hard, just because that is easier. 'Voting with their feet' is another: If shareholders invest indifferently in both the best and the fourth-best firm in an industry, that will keep up the fourth-best firm's stock price and lower the best's, reducing incentives to be the best. Or there is just fiduciary duty: Managers may want to do what's in their shareholders' best interests because that is what they are supposed to be doing. Even if the shareholders don't actively force them to."
In fact, as I understand it, index investing is just an end-spectrum case of institutional investing in general, and "Posner and Weyl blame institutional investors for income inequality. Elhauge blames them for runaway executive pay, and for the rise in corporate profits unaccompanied by economic growth and investment."
Runaway executive pay, for example, seems to be a consequence of interlocking executive roles: the manager of this company is a director of that, and vice-versa, resulting in a positive feedback loop.
I am, and have been for a long time, a major index investor; a big chunk of my portfolio is in various indexes. But it's already the case that a good way to get an extra boost is to buy the shares of a company just before it enters the S&P500. If the indices are having effects in the other direction, there may be problems in store.
This is a fascinating line of thought and, at least from a game theoretic perspective, seems to be a mechanism for creating automatic, passive collusion between companies.
If we model the market as a prisoner's dilemma where a lawyer is deciding whether their client should defect or not, mutual defection is the normal Nash equilibrium. But if both lawyers are representing the same client then cooperation becomes the dominant strategy: regardless of what the other lawyer does (cooperate-defect and cooperate-cooperate both have higher total payoffs than defect-defect).
Notably, this mechanism is entirely passive: it requires no communication between managers or even managers and their investors. Merely knowing that my investors are also investors in my biggest competitor would make "cooperation" the dominant strategy without requiring any conscious collusion.
Taken to the extreme, this actually undermines the entire free market: every manager in a 2+ place firm would have a fiduciary responsibility to drive their company out of business so that the first place firm could enjoy monopolist profits (and thus maximize their shared investor's total return).
Which institutional investor should I specifically be concerned about?
Show me the institutional investor that owns 30% of American, 30% of Delta, 30% of Southwest, and 30% of United. [1] If this is the case, then yes we have a problem. The manager of this fund has a major incentive to have these 4 major firms collude and price gouge its customers, as competition among the firms would minimize profit for the index fund. It would major shares of the companies that own the entire market. I think it's safe to say that this institutional investor doesn't exist.
Which concentrated group of 3-4 (oligarchy) institutional investors own a combined 50% of American, 50% of Delta, 50% of Southwest, and 50% of United?
If this is the case, then yes, we have a problem. Collusion will occur between these funds, who will agree to use their voting/management rights to collude at the airline level, as they own the companies that own the market.
We're usually used to seeing collusion between the CEO's and boards of major companies in concentrated markets because we tend to think of these people as the people who profit the most from price gouging. Antitrust lawsuits against AT&T, Kodak, Standard Oil - these are all pretty concrete examples of collusion from brands that we (used to) interface with. [2]
Now we could be seeing collusion abstracted one layer - the owners/shareholders are institutional investors who don't have a well-known brand. Which institutional investors specifically should we be worried about? Unlike AT&T + Verizon, I don't interface directly with any of them, so I'm not sure which firms I should be concerned about.
Based on the latest market data, the largest holder of AAL, DAL, LUV, and UAL is Vanguard which through various mutual funds owns 11.5% of the total market value of those four airlines. Second largest holder is T.Rowe Price with 6.8% of the total ownership. Concentration of ownership goes down rapidly from there. So it's hard to see this as a real problem.
Why the assumption that an index must represent a market?
Wikipedia def:
"An index fund (also index tracker) is an investment fund ... that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions."
The OP only discusses the former, not the later. I see the point that an indexed fund tied to a specific market, the narrower the better, may bring antitrust rules into play. But the later concept, that a indexed fund is simply a fund with fixed buy rules, need not get anywhere close to antitrust. They need not have a presence across any "market" as conceived by antitrust.
How about an indexed fund with the rule: Own equal numbers of share from all publicly-traded social media firms, except facebook. Such an indexed fund might find lots of investors without getting anywhere close to antitrust.
Sure, index funds can track any sort of index, and use any sort of weighting scheme. But modern portfolio theory dictates that truly passive investors should hold two assets: the "market portfolio", and a "risk-free" asset such as Treasury bonds, or cash.
As other commenters have mentioned, "index investing" is better referred to as "passive investing".
I think the very term "indexed fund" is an artifact. Indexed funds need not be tied to an index. They can still be "passive investing" without the index.
"Antitrust" is a similar linguistic artifact as you can violate antitrust rules without any mention of trusts,
I agree we should get away from the term "index fund", but for better or worse, investors are hung up on indices. Why do we talk about the S&P 500? Why not 1k? etc.
Ick, a third overlapping term. I would call purely quant funds a form of indexed funds in that they follow a specific set of rules. Those rules are whatever procedure, computer program, or other non-human algorithm is used to pick investments.
Whether or not a quant fund is passive investment is semantics imho. I wouldn't call spending hours/days/weeks examining a quant funds system a passive activity. And investors can move in and out of funds quickly these days. On the other hand many see passivity wherever investors or fund managers put buy/sell decisions in the hands of non-humans.
If index funds create larger voting blocks of shares, wouldn't that create a more powerful pool of voting power to influence changes than if all shareholders were voting individually? Index funds could turn over voting control to a proxy/research based voting service or survey their investors to determine how to vote.
I'm embarrassed to admit I actually don't know the voting policies of the major index funds I'm invested in (VTI, AGG mostly).
Index funds effectively buy and sell at prices set by non-index fund investors. They are reacting to market price, not trying to predict where the stocks will go in the future.
All other investors are betting on the future price moving one way or the other.
I'd argue that index funds are an amplifier for demand, but that the actual demand is still generated based on 'analysis' by investors seeing the the current price as an opportunity.
The article's focus on the temptation for collusion seems overblown to me. Yes, the interests of Pepsi+Coke's index shareholders are served if the companies avoid cannibalizing each other's value, but those shareholders have no way to apply pressure on the companies to do that. Index shareholders do not vote, and by their nature cannot sell shares of a company that they are displeased with.
The other concern seems more well-placed. An efficient market requires that shareholders buy and sell companies in response to performance. Index funds buy and sell companies in response to the performance of the fund, or the market as a whole, or some other arbitrary factor. If 50% or 80% or 90% of a company is owned by 'dumb' funds, what does that do to their market value? And how could that affect the choices of the CEO?
Say index funds become illegal, just for the sake of argument. Aren't they replaceable by an algorithm - trading software that balances a portfolio that copies an index per investor? It's less efficient, of course, but it's essentially the same thing. You get millions of tiny, cross-sector owners instead of few big index funds. So in that sense the argument in favor of banning index funds is really pointless. They're just one implementation of a strategy that investors could follow on their own, just less efficiently. Essentially, banning them is just a way of enriching brokers because of the expected rise in transaction fees.
index allocation as a % of total assets will keep rising, but total assets will also keep rising.. That means individual stocks will still have price discovery despite a futuristic scenario where 99% of all money is indexed. The mechanism for how this leads to collusion is unclear.
For an individual index fund, who is making the argument that it's big enough for anti trust? If one fund owns 1% of American Airlines, and 1% of United Airlines, they have no monopoly/dominating power over either.
As someone who derives most of his income from the value created by start-ups disrupting incumbents, I'm all in favor of index funds making firms anti-competitive in their own industries.
Matt Levine is awesome at separating arguments from interests, and writes very clearly. He was great on Dealbreaker, and I'm glad that he's not tempering his voice on Bloomberg.
One problem with this argument is that it ignores the fact that investors are also consumers. If the representative investor is also the representative consumer, then managers who aim to maximize shareholder utility will not set monopoly prices, but rather competitive prices! Of course, like the author I don't think any of this bears out in reality.
Index fund works well because it's diluted. When you invest in a single company there are many unknowns and downsides but stretched across the sector, you find less risk (how likely is it that other than Toshiba and Kodak are cooking books).
However, the returns are also limited to the sector as well.
I admit picking undervalued companies AND being solvent enough before the market reacts rationally is a huge undertaking and why there's so little of successful value investors.
It happens every time, if there a way to make money speculators will come into the market, take advantage of it. Or in the case of index funds, it will become overcrowded and inefficient and the market will move on to the next big thing. Just ask LTCM. It's the invisible hand of the market...
Honestly, anybody that down voted me is probably invested heavily in index funds because they heard something on a blog and listened to Warren Buffet once.
80% and shrinking of the fund market is closed and proprietary software. Its very expensive and relies on single points of failure, often one person per fund. There's a lot of propagandizing that they're the only way to invest or best or whatever.
20% and growing of the fund market is free open source allocation, here is TODAYs definition of an index now buy stock to reflect it. Needless to say its incredibly cheap compared to the closed source funds and arguably gives an overall higher rate of return.
Some of the lower rate of return of closed source funds is because of their massive advertising and propaganda budget spent to convince investors that they're a better deal. Sometimes, by obscure enough definitions of better deal, they are. Usually not. Needless to say someone who's paycheck depends on FUDing the free competition isn't going to have anything nice to say about FOSS or index funds.
The idea that FOSS or an index fund is a conspiracy is kind of weird. If index funds are made illegal on that ground, I suppose Emacs will be made illegal soon because its unfair to make individual proprietary editor writers compete with the entire world teamed up against them. "The right of the rich to privatize gains and socialize losses shall not be infringed" and possibly other constitutional amendments will be marched out in the corporate press, etc.
The article is not about index funds competing with alternate investment opportunities and whether or not the competition is fair, it's about what index funds do to the competitiveness of the companies they invest in.
I know that companies don't necessarily benefit directly from an increasing stock price, but in reality it allows them to raise capital by issuing new shares with less dilution. Also it makes it costlier for smaller competitors to raise capital, crowding out competition. At the end of the day, the "antitrust" question is not about Apple v. Microsoft... it is moving more in the direction of "Apple & Microsoft" vs. anyone trying to claw and scrape their way into the game.