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Does the rise of passive indexing create opportunities for stock picking?


saltybit

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"asset flows into funds and ETFs tracking the S&P 500 boost the valuation (price-to-earnings ratio or price-to-book ratio) of stocks included in the index anywhere from 139 to 167 basis points as compared to stocks left out of the index."

 

How long does this effect take on average? If you can do 1.4% over two weeks that's a pretty good source for statistical arbitrage.

 

"In theory, it would only take one profit-seeking active manager to correct any security mispricing and keep security prices in line with fair values." - Mike Rawson

 

Right, that's how you can tell your theory is broken.

 

If you can't bother fixing your broken theory, it's probably better to have no theory at all.

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One phenomena I've read about (I think it was mentioned in the "Future for Investors") is how passive index strategies creates zombie investors who continually prop up asset prices. For example, imagine how much money is flowing into the S&P 500 companies, and of that, a huge chunk just keeps going towards Apple since its capitalization weighted. Once these zombie investors want to take their money out in large numbers, there may be a semi crash-like scenario, since the stocks were propped up by being bought into blindly.

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One phenomena I've read about (I think it was mentioned in the "Future for Investors") is how passive index strategies creates zombie investors who continually prop up asset prices. For example, imagine how much money is flowing into the S&P 500 companies, and of that, a huge chunk just keeps going towards Apple since its capitalization weighted. Once these zombie investors want to take their money out in large numbers, there may be a semi crash-like scenario, since the stocks were propped up by being bought into blindly.

 

But of course, a majority of that money is retirement/savings/pensions/401ks etc.

 

So that money doesn't just all come out at once. In special circumstances (2008) it might, but over the long-term, those SPY positions are slowly sold off, transferred to bonds, etc. as people age, as the population bracket below them pours more into SPY to plan for their retirement. It's constantly rolling itself over with the population.

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But of course, a majority of that money is retirement/savings/pensions/401ks etc.

 

So that money doesn't just all come out at once. In special circumstances (2008) it might, but over the long-term, those SPY positions are slowly sold off, transferred to bonds, etc. as people age, as the population bracket below them pours more into SPY to plan for their retirement. It's constantly rolling itself over with the population.

 

True, but the argument Siegel presented is that the younger generations won't be investing in the same assets as they are sold fast enough, meaning the stock prices, which have been, to a degree, artificially propped up as a result of forced investment in retirement vehicles, may drop. This makes sense to me. Think of the number of people with Masters and Doctorates working as baristas with massive educational debt. Unless asset flows come from overseas, the largest companies may have a problem asset-price wise.

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But of course, a majority of that money is retirement/savings/pensions/401ks etc.

 

So that money doesn't just all come out at once. In special circumstances (2008) it might, but over the long-term, those SPY positions are slowly sold off, transferred to bonds, etc. as people age, as the population bracket below them pours more into SPY to plan for their retirement. It's constantly rolling itself over with the population.

 

True, but the argument Siegel presented is that the younger generations won't be investing in the same assets as they are sold fast enough, meaning the stock prices, which have been, to a degree, artificially propped up as a result of forced investment in retirement vehicles, may drop. This makes sense to me. Think of the number of people with Masters and Doctorates working as baristas with massive educational debt. Unless asset flows come from overseas, the largest companies may have a problem asset-price wise.

 

Companies also repurchase their own shares, the buyers don't have to be baristas with debt. 

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Companies also repurchase their own shares, the buyers don't have to be baristas with debt. 

 

True, but the very fact that money flows in and out of these 500 companies as a group means there is the potential for it to be systemic. "Investors" in indexes are buying without any reflection of the price they are paying, so there is a build of irrationality in the pricing.

 

I would actually think of this manner of investing as a form of price leverage. When so many cubicle dwellers got skittish in 08/09, they indiscriminately sold all 500 of these companies. The swings are therefore more pronounced than if they assembled their basket of companies individually.

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True, but the very fact that money flows in and out of these 500 companies as a group means there is the potential for it to be systemic. "Investors" in indexes are buying without any reflection of the price they are paying, so there is a build of irrationality in the pricing.

 

I would actually think of this manner of investing as a form of price leverage. When so many cubicle dwellers got skittish in 08/09, they indiscriminately sold all 500 of these companies. The swings are therefore more pronounced than if they assembled their basket of companies individually.

 

I don't understand why you focus on 500 companies. Passive funds track all kinds of indexes. Yes, S&P 500 is the most popular index by far, but it's not the only index that attracts massive inflows.

 

Largest ETFs by assets

http://etfdb.com/compare/market-cap/

 

SPY and IVV are #1 and #3. Both track S&P 500.

QQQ is #4. It tracks NASDAQ.

VTI is #6. It tracks broad US market (3000+ companies).

IWM is #9. It tracks Russell 2000 (US small caps).

 

WSJ P/E data:

 

http://online.wsj.com/mdc/public/page/2_3021-peyield.html

 

Russell 2000: 86.73

S&P 500: 18.91

 

Small-caps as a group are far more expensive than large caps.

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@ Racemize:  etfdb.com shows the ETFs that includes a stock.

 

thanks!

 

Turns out a lot of my stocks aren't really in indexes.  Interesting.

 

it looks like that tool only displays stocks that are in a fund's top 10 holdings, not any stock held by a fund.

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I dont believe it for a second.  Here's why: Retirees need income, and borrow less.  Interest rates should stay low for the foreseeable future, perhaps not this low but low enough.  Companies like to have shareholders.  In order to keep a good base of shareholders companies will be forced to give back earnings as dividends at a greater rate than presently.  Stocks that pay high dividends will do best. 

 

In the present climate where interest rates on the 10 year are 2.7% any company that can pay a dividend better than 4% (a 50% risk premium) will have easy access to capital.  This is more in keeping with historical norms where the bulk of earnings were paid back to shareholders, than the last 30 years. 

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@ Racemize: do you have a Bloomberg terminal?

 

I do not, I was hoping for a public (read free) resource.  =p

 

Yes there is one, someone alerted me to it probably two years ago when Stahl was writing about indexes.  You can put in a ticker and it would show you what indexes the stock was a part of.  It also showed similar stocks not in indexes.  I don't remember the name of the site, it was something like ETFUniverse or something like that. 

 

I feel bad this isn't that useful of a comment.  My point is there is/was something, continue to Google madly and you'll find it.

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this is great for investors right? decades of underpriced assets, just shoot and you'll hit. i have no idea whether this will happen or not, but i wouldn't mind one bit.

 

Right, as long as you are young and have money coming in from somewhere, or can be be a miser (and never touch principal, a la Trina from "McTeague") and eat cat food ;)

 

I don't know how pronounced this asset price inflation effect is overseas, but I'd say that it's definitely here in the US. Every $100 tossed into retirement leads to at least $5 going to Apple with hardly a thought to price, valuation, goals, etc.

 

 

 

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