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20 Years Ago - Ackman Question to Buffett & Munger on Indexing


Parsad
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Bogle addressed the aspect of fund managers voting proxies in Clash of the Cultures.

 

There doesn't appear to be too much expense in voting proxies unless you consider a poorly researched voting decision which rubber stamps the BOD resulting in subsequent mediocre or poor performance of the company itself.

 

You'd think that managers would want to improve outcomes by voting effectively.

 

On another note; I've read some opinions about the possibility of indexing diverting capital from promising new businesses.

 

It seems like the PE firms & hedge funds which we criticize so heavily for the highly publicized "unicorns" may, in part take up the slack & fund some very worthy (as yet unhorned) startups for future inclusion into an index...

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Seems to me that most of the issues created by indexing are all self-solving.  If indexing drives more and more capital to fewer and fewer ideas, pockets of value will open up - and there is no shortage of smart people picking the market over looking for them.  Capital will, eventually, go where the need (and return) is greatest.

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Seems to me that most of the issues created by indexing are all self-solving.  If indexing drives more and more capital to fewer and fewer ideas, pockets of value will open up - and there is no shortage of smart people picking the market over looking for them.  Capital will, eventually, go where the need (and return) is greatest.

 

Indeed. I was more seeing this as good news. A creating (and/or increasing) driver of opportunity.

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Seems to me that most of the issues created by indexing are all self-solving.  If indexing drives more and more capital to fewer and fewer ideas, pockets of value will open up - and there is no shortage of smart people picking the market over looking for them.  Capital will, eventually, go where the need (and return) is greatest.

 

++

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Seems to me that most of the issues created by indexing are all self-solving.  If indexing drives more and more capital to fewer and fewer ideas, pockets of value will open up - and there is no shortage of smart people picking the market over looking for them.  Capital will, eventually, go where the need (and return) is greatest.

 

While I agree, is anyone concerned about a potential trade-off between more opportunities and the time it takes for intrinsic value to be realized from them?  Finding opportunities is only half the battle.

 

My understanding is this becomes a double edged sword.  I agree with the notion that capital should flow where return is greatest, but as indexing continues unabated, that big capital is increasingly precluded from flowing back and raising multiples.  It's like we can't have it both ways.  (Unless of course indexing loses favor and sentiment shifts back to active management.)

 

To the extent that value investing is about finding cheap companies and waiting for them to no longer be cheap, doesn't vast indexing remove a powerful catalyst?

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Seems to me that most of the issues created by indexing are all self-solving.  If indexing drives more and more capital to fewer and fewer ideas, pockets of value will open up - and there is no shortage of smart people picking the market over looking for them.  Capital will, eventually, go where the need (and return) is greatest.

 

While I agree, is anyone concerned about a potential trade-off between more opportunities and the time it takes for intrinsic value to be realized from them?  Finding opportunities is only half the battle.

 

My understanding is this becomes a double edged sword.  I agree with the notion that capital should flow where return is greatest, but as indexing continues unabated, that big capital is increasingly precluded from flowing back and raising multiples.  It's like we can't have it both ways.  (Unless of course indexing loses favor and sentiment shifts back to active management.)

 

To the extent that value investing is about finding cheap companies and waiting for them to no longer be cheap, doesn't vast indexing remove a powerful catalyst?

 

While it's ideal if stocks re-rate from the second you buy them and you never run out of good ideas that re-rate hte second you buy them, that's not reality. There's a great long-term opportunity in perpetually discounted securities - particularly if they pay dividends or repurchase stock. You can compound at much higher rates, more continuously, and need to do less work to monitor them.

 

If you have a stock at 4-5x earnings that pays a modest dividend (or modest repurchase program) and you can re-invest that dividend at 4-5x earnings for the next 20 years, you're probably not going to be complaining about your results even if the stock never re-rates to more a normalized multiple.

 

 

 

 

 

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Indexing does not remove acquisitions, doesn't remove private buyouts.

 

For the rest of this post I talk about market-cap based indexing. There's a lot of other indexing, which is harder to reason about. Some of other indexing is pro-valuation-rerating (value weighted indexes), some is neutral, some is contra.

 

Market cap based indexing is neutral in terms of valuation rerating. I.e. unlike what some people think, if company X has market cap Y and its market cap rises to Y+Z or drops to Y-W, index funds do not buy or sell X. So in essence index funds remove float, which should cause a faster valuation rerating if such occurs. (This is not true if company is not in the index - so yeah, that's a potential issue if everyone buys SP500 rather than Total Market Index. But it's not clear if SP500 will become "overindexed" compared to the rest of the market).

 

Market cap based indexing is also valuation rerating neutral for inflowing money. Some people argue that this is not the case, but any new money buys percentage of companies stock based on their market caps. So the effect on valuation is the same for all companies in the index (for both company A with market cap 100B and company B with market cap 100M additional money buys the same percentage of market cap, so stocks of both presumably go up the same, changing valuation the same percentage. this can be distorted for low float companies though.)

 

In general though, pushing something to "logical extreme" is usually not a good mental model. First of all, most things are broken if pushed to logical extremes. Second, most things are not broken precisely because they never go to logical extremes. So usually when someone presents an argument that X is bad because it's bad at its logical extreme, the argument is flawed.

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Market cap based indexing is neutral in terms of valuation rerating. I.e. unlike what some people think, if company X has market cap Y and its market cap rises to Y+Z or drops to Y-W, index funds do not buy or sell X. So in essence index funds remove float, which should cause a faster valuation rerating if such occurs. (This is not true if company is not in the index - so yeah, that's a potential issue if everyone buys SP500 rather than Total Market Index. But it's not clear if SP500 will become "overindexed" compared to the rest of the market).

 

When do they buy/sell?

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I was looking for a comprehensive answer which is why I asked. But if I had to guess:

 

1) obviously when any stock gets removed or added to the index. Although I am not sure the actual mechanics of this.

 

2) by market makers of the etf. Who would be redeeming/creating etf shares in exchange for baskets of the underlying stock continuously each day. They should be able to arbitrage away small differences between the actual value of the underlying shares and the baskets of stocks. This would be done to balance supply/demand. So if tonnes of people bought the vfv then the vfv price would increase beyond the value of the underlying basket of stocks. Market makers would then buy huge blocks of the underlying stocks and exchange them with Vanguard for etf units which they would then use to satisfy market orders from retail customers who would be buying the actual etf shares. This would enable the market makers to obtain arbitrage profits equivalent to the difference between the price retail customers pay and the price of the actual underlying basket of shares. This should keep the difference between the ETF value and basket value small.

 

This implies that the market impact of ETFs will be dominated by investor flows, and ETF removals/additions.

 

Anyways the best understanding other than Jurgis I have seen so far of this issue can be found here:

http://www.philosophicaleconomics.com/2016/05/passive/

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