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Unintended consequences of indexing


tede02
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Have you ever thought about possible unintended consequences of indexing?  Today the WSJ reports that Vanguard saw inflows of $214 billion in 2014 alone.  I’ve been thinking about this issue more recently.  Will market dynamics change somehow as more and more “mind-less” money gets sloshed around (or is most of the money already mind-less)?  Will market-cap weighted indexes add to the bubble effect and boom and bust cycles?

 

(For the record, I’m not against passive investing at all.  It seems like a very sound strategy for many individuals with no interest or time to actively manage their investments). 

 

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Have you ever thought about possible unintended consequences of indexing?  Today the WSJ reports that Vanguard saw inflows of $214 billion in 2014 alone.  I’ve been thinking about this issue more recently.  Will market dynamics change somehow as more and more “mind-less” money gets sloshed around (or is most of the money already mind-less)?  Will market-cap weighted indexes add to the bubble effect and boom and bust cycles?

 

(For the record, I’m not against passive investing at all.  It seems like a very sound strategy for many individuals with no interest or time to actively manage their investments).

 

I thought the same thing when reading that article last night. 

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I don't know if the increasing popularity of indexing will have a big effect. You could argue that in the past a large amount of money was already effectively indexed by funds with a closet index hugger as manager. Perhaps what you see now is mostly people realizing that they can achieve the same result with lower costs?

 

An additional question: how much "smart money" do you need for efficient price discovery? It could be that we are far away from a point where indexing would impact price discovery in a meaningful way.

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I don't know if the increasing popularity of indexing will have a big effect. You could argue that in the past a large amount of money was already effectively indexed by funds with a closet index hugger as manager. Perhaps what you see now is mostly people realizing that they can achieve the same result with lower costs?

 

An additional question: how much "smart money" do you need for efficient price discovery? It could be that we are far away from a point where indexing would impact price discovery in a meaningful way.

 

Stahl had a piece in 2012 I believe that talked about this.  He showed valuations of index components and then valuations of competitors that weren't in the index.  In a few cases the competitors had better operating metrics and were selling for lower prices.  The discrepancy could be attributed to the mindless buying of indexes.  After reading this piece I was pointed to the website Stahl used to research this.  I've since lost my notes and don't remember it, but it was cool to see.

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Guest longinvestor

The easy money funds make off fees is threatened by this trend towards low cost index funds. But the largest cache lies in 401K's and the fund industry stands to lose the most if index funds are aggressively pursued there. Not sure if they even offer lower fee investment options in all 401k's. They don't have to, do they? There is no competition there at all. A generation of savers are pi$$ing away their money through fees in 401K's. IMO, this is an even bigger travesty than the social security funding issue.

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An additional question: how much "smart money" do you need for efficient price discovery? It could be that we are far away from a point where indexing would impact price discovery in a meaningful way.

 

I think this really nails it.  Personally I think there is enough smart money that prices are fairly efficient.  If you get into micro-cap land there are inefficiencies for sure but that isn't related to indexing.

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I don't know if the increasing popularity of indexing will have a big effect. You could argue that in the past a large amount of money was already effectively indexed by funds with a closet index hugger as manager. Perhaps what you see now is mostly people realizing that they can achieve the same result with lower costs?

 

An additional question: how much "smart money" do you need for efficient price discovery? It could be that we are far away from a point where indexing would impact price discovery in a meaningful way.

 

Stahl had a piece in 2012 I believe that talked about this.  He showed valuations of index components and then valuations of competitors that weren't in the index.  In a few cases the competitors had better operating metrics and were selling for lower prices.  The discrepancy could be attributed to the mindless buying of indexes.  After reading this piece I was pointed to the website Stahl used to research this.  I've since lost my notes and don't remember it, but it was cool to see.

When one company is in the index but another is not there is usually something going on that makes it an apples to oranges comparison. If the stocks would be nearly identical with regards to size, liquidity, float etc they would both be in the index.

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I couldn't find a relevant article by Stahl.  If someone could link it. 

 

I dont see how indexing changes anything except killing fees for intermediaries.  In market weighted indexes stocks still go up and down getting constantly re-weighted. 

 

On the other hand, indexing may exaggerate event effects of pricing.  A stock, say JPM, has a price drop due to a trading incident.  The indexes need to re-weight and sell JPM, further crushing the price.  If anything, the indexes themselves will become more volatile, creating more opportunities for contrarians.  The ETFs tracking indexes will lose some of their correlation if this becomes extreme. 

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On the other hand, indexing may exaggerate event effects of pricing.  A stock, say JPM, has a price drop due to a trading incident.  The indexes need to re-weight and sell JPM, further crushing the price.  If anything, the indexes themselves will become more volatile, creating more opportunities for contrarians.  The ETFs tracking indexes will lose some of their correlation if this becomes extreme.

 

From my understanding since these indexes are all marketcap-weighted there is no additional rebalancing necessary. But stocks that fall out of an index can be hit harder the more money was in the ETF. Perhaps that is the best hunting ground for value picks in the future.

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Stahl is talking his book. The wealth index is showing little outperformance versus S&P 500 equal weight which would be the closest comparable index that he lists and the entire outperformance over this period can be explained by any one of two years - 1999 or 2009. A slightly better index would have been S&P 400 mid cap index. Even this small outperformance is achieved via much higher volatility.

 

So if you adjust for just one factor (size) nearly all of the outperformance disappears.

 

Vinod

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It's pretty cool to contrast the thinking of an EMH indexer (Zweig):

 

http://blogs.wsj.com/moneybeat/2014/02/28/emerging-markets-look-appetizing-again/

 

with the thinking of a value guy (Stahl):

 

http://frmocorp.com/_content/essays/EmergingMarketsasanAssetClassJuly2014.pdf

 

Both of these articles were written earlier last year.  Lots of index investors annually rotate out of sectors/markets and move funds into those that underperformed.  They should not fool themselves that they are getting a better "value" just because of relative underperformance, because all they are looking at is market prices.    To state the obvious on this board, value investors know that price does not equal value, even if prices fall a lot.

 

Still, it's humbling for most active managers to see the indexers outperform.

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I have had this topic rattling around in my head all day.  I think the ultimate proof is in the performance of the stock pickers and from that perspective I don't see the evidence.  I know there are some managers who have had great years but there are many "gurus" with 5 and 10 year track records that have under-performed the S&P500.  That just shouldn't be happening if indexing is making the market less efficient.  How does a concentrated investor like bruce berkowitz underperform for a decade if markets have become inefficient?

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Great discussion.  This article has some eye opening numbers around how big indexing has become. 

 

http://www.thinkadvisor.com/2014/09/29/the-perils-of-the-indexing-crowd

 

The quote that really resonated with me was: "It is a law of investing that when something very successful starts to become too popular, past a certain point, risks will form where none existed before." 

 

One of the problems also seems to be defining indexing as one specific thing.  Market-cap weighted indexes surely will have different effects on the market than will an equally weighted index.  Also, these days there are ETFs that track very specific sectors and individual countries.  This seems to complicate the issue further. 

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Well one of the consequences intended or unintended is more indexing or rather different indexing. It all started as someone pointed out with the equal weight indexes, which recently have outperformed, but primarily because they hold more mid-cap stocks than anything else. I believe there is also all the research by French and Fama and the creation of Dimensional financial advisor funds. The recent craze seems to be smart beta? Take a look at the creation of all the fundamentally weighted indexes that wisdom tree MorningStar and others have put together. Not to mention Joel Greenblatt. Basically because active managers have not been able to beat the index people are now trying to find flaws in the construction of the standard market capitalization indexes. Of course it all makes sense in theory, the big question will be what the practice going forward will look like. It's easy to back test theories and make them look good, but it will be interesting to see how they pan out going forward especially taking into account taxes and fees. A market cap weighted index as some have pointed out is incredibly tax efficient, and if you add on the impressively low fees, it's a pretty tough bogie to beat.

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  • 5 weeks later...

Bringing this topic back to life briefly.  I spoke to a guy representing iShares today.  According to him, ETFs have gained a lot of popularity in the US, but worldwide, there has been very little adoption.  Perhaps indexing also has a looooong way to go. 

 

On another note, I've been thinking recently that indexing is much more likely to be popular when markets are moving up.  And since 2009, all major asset classes have done just that (although precious metals and commodities have been weak in recent years).  You can understand the mentality of "Why should I pay someone who can't beat the S&P?"

 

However, I would be willing to bet that as soon as we get some significant market turbulence, particularly a year or more of significant negative market performance, people will be out searching for a "new mouse-trap," eager to hear a new story.  After 2008, the "new mouse-trap" marketed by Wall Street was "tactical" investing.  What a joke.  "Tactical" was basically another word for market timing. 

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This is a great question.

 

I see 2 main effects of a greater percentage of money in index funds:

1.  Less "free float"

2.  Greater Non-value based buyers.

 

Let us imagine that indexing goes from 0% to 99% of all funds - an extreme example.

I think with less free float there could be additional volatility creating more opportunity for those who are value oriented.

 

In addition there should be a lot less competition as the number of true investors researching absolute value goes down.

 

Probably good for the remaining active value investors.  Tricky though.

 

The other thing I have recently realized is that some huge percentage of people don't really know what the index they are buying is worth.  I am talking about long term oriented investors too.  I have seen it too many times now.  Reits and small caps are very expensive now and people are piling in.  They don't know the value at all.

 

 

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This is a great question.

 

I see 2 main effects of a greater percentage of money in index funds:

1.  Less "free float"

2.  Greater Non-value based buyers.

 

Let us imagine that indexing goes from 0% to 99% of all funds - an extreme example.

I think with less free float there could be additional volatility creating more opportunity for those who are value oriented.

 

In addition there should be a lot less competition as the number of true investors researching absolute value goes down.

 

Probably good for the remaining active value investors.  Tricky though.

 

The other thing I have recently realized is that some huge percentage of people don't really know what the index they are buying is worth.  I am talking about long term oriented investors too.  I have seen it too many times now.  Reits and small caps are very expensive now and people are piling in.  They don't know the value at all.

 

 

 

Regular index investing is premised on the efficient-market hypothesis. It should be completely value-agnostic. The idea is that you don't know whether a bubble will keep on going, and you don't want to miss out, so you just keep on dollar-cost-averaging in. In the long run, this will work out, as you also keep steadily buying in during market declines.

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This is a great question.

 

I see 2 main effects of a greater percentage of money in index funds:

1.  Less "free float"

2.  Greater Non-value based buyers.

 

Let us imagine that indexing goes from 0% to 99% of all funds - an extreme example.

I think with less free float there could be additional volatility creating more opportunity for those who are value oriented.

 

In addition there should be a lot less competition as the number of true investors researching absolute value goes down.

 

Probably good for the remaining active value investors.  Tricky though.

 

The other thing I have recently realized is that some huge percentage of people don't really know what the index they are buying is worth.  I am talking about long term oriented investors too.  I have seen it too many times now.  Reits and small caps are very expensive now and people are piling in.  They don't know the value at all.

 

 

 

Or it may be worse of active value investors, since all the non-value investors and dumb money are investing in ETFs, the only remaining investors that compete with each other are smart active value investors?  :o

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