Will Indexing Kill the Market?

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mickeyd
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Will Indexing Kill the Market?

Post by mickeyd » Wed May 01, 2013 3:02 pm

The author seems to believe that indexing could actually be a factor in active fund underperformance. It's an interesting theory.
Up until now potential negatives from indexing were mostly academic observations. NYU professor Jeffrey Wurgler’s 2010 paper “On the Economic Consequences of Index-Linked Investing” summarizes nearly 40 studies about indexing that go back as far as 1986. He shows us quite convincingly how and why indexing has been affecting the market and its components for decades.

When a stock becomes part of an index its behavior changes instantly. “It is as if it has joined a new school of fish,” Wurgler writes. In summarizing the implication of all of these studies he turns the conventional wisdom about indexing on its head: “The popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average to beat the index; it may actually be contributing to their underperformance.” If Wurgler is even close to being right, our perception of indexing may be due for a major adjustment.

Some observers have suggested that indexing will never become large enough to pose a systemic threat to the market because there will always be enough investors to offset the mispricing that excessive indexing might produce. However, in the real world extreme behavior in markets is driven by powerful forces and rarely has a benign end. I’m reminded of the quote, often attributed to Lord Keynes, that “Markets can remain irrational longer than you can remain solvent.”
http://www.advisorone.com/2013/04/29/wi ... =dailywire
Part-Owner of Texas | | “The CMH-the Cost Matters Hypothesis -is all that is needed to explain why indexing must and will work… Yes, it is that simple.” John C. Bogle

leonard
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Re: Will Indexing Kill the Market?

Post by leonard » Wed May 01, 2013 3:42 pm

No. Doesn't take much arbitrage to keep the market efficient.
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Scooter57
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Re: Will Indexing Kill the Market?

Post by Scooter57 » Wed May 01, 2013 3:59 pm

It would be interesting to know how much institutional money is now in ETFs. This is an issue I've been wondering about since I started seeing individual stocks moving in lock step with their sectors.

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Re: Will Indexing Kill the Market?

Post by nisiprius » Wed May 01, 2013 4:01 pm

It's not an interesting theory; it's a stupid theory, easily refuted, that's been around for as long as there have been index funds. The only reason it persists is because it's a standard "talking point" against indexing.

Any easy way to refute it is to ask how it can possibly be true that "When a stock becomes part of an index its behavior changes instantly," if the index in question happens to be a total market index.

It is also hard to understand how indexing could hurt active managers (other than by exposing their inability to beat the market after expenses...) Surely it should be exactly the reverse--if active managers really can beat the market, they should be sucking money into the actively managed funds and away from the passive funds. The more investors who opt out and simply track the market, the more fools there are who are passively pumping money into the market, but taking out less than they would if they invested actively. That means more goodies for the active managers to share, with a smaller number of investors.

As for price discovery, you and I don't do that. If weighed by dollars, it is a small percentage of the number of people in the market who do that: professionals, big institutional investors. And a few computers, of course. Anyone who really does have important and unique insights into stock valuation isn't going to index, they will exploit those insights and contribute to the noble work of price discovery. Nothing is lost when people without special abilities for valuing stocks opt out of price discovery.
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nisiprius
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Re: Will Indexing Kill the Market?

Post by nisiprius » Wed May 01, 2013 4:09 pm

http://www.dimensional.com/famafrench/2 ... dexed.html
EFF/KRF: This is a complicated question that we address at length in "Disagreement, Tastes, and Asset Prices" (Journal of Financial Economics 2007). The answer depends to some extent on who turns passive. If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.
Also answered by Allan Roth, If Everyone Indexed and Larry Swedroe What would happen if everyone indexed?
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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Re: Will Indexing Kill the Market?

Post by FafnerMorell » Wed May 01, 2013 4:31 pm

I wonder if active fund managers get depressed about the futility of their jobs, or if the money is good enough they don't care, or if it's something like what generals felt during WW1 were they'd send off 20,000 soldiers to die each day to no real effect, and they'd do it again day after day because they couldn't think of what else to do. Or maybe they do get depressed and spend some of their cash to pay academics to write papers like this.

"Look, the only reason indexes win is because I'm around to lose - if I wasn't here losing, they wouldn't be winning - they'd be out of control. So give me your money to manage, and pay my fees, and don't complain".

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Re: Will Indexing Kill the Market?

Post by lawman3966 » Wed May 01, 2013 5:25 pm

From what I've read, for most of market history, most stocks have been controlled through active management. In this situation, since actively managed portfolios, cumulatively, ARE the market, they could not outperform it.

If this changed, and most stocks were owned through index funds, and by total market index funds at that, it might then become possible for index trading to cause significant stock mispricing.

My assumption is that if such mispricing occurred, for example by causing stock A to fall with a declining index though it didn't deserve the decline on its own merits, that active traders would swoop in and buy stock A for its dividend yield and hold it until the price rose to some suitable multiple of the annual dividend (or other metric). Moreover, very few traders would be needed to perform this re-pricing function.

Does the board agree that this would work as a valid re-pricing mechanism?

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Re: Will Indexing Kill the Market?

Post by Scooter57 » Wed May 01, 2013 6:28 pm

The indexing they are talking about isn't just the total stock market. But when SPY is the most heavily traded security every day for months, and when other popular ETFs are the focus of option buying in huge amounts the fact so many stocks are being bought and sold as a unit might become significant.
Last edited by Scooter57 on Wed May 01, 2013 8:34 pm, edited 1 time in total.

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C8H18Engineer
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Re: Will Indexing Kill the Market?

Post by C8H18Engineer » Wed May 01, 2013 7:24 pm

Bogle's latest book quotes institutional ownership in general in the 70% area... I don't remember if that was ETF's or the market in general. That along with ever shorter trading schemes could have the effect you are talking about - all moving in lock-step.

I was looking at my one index fund (SSgA S&P 500) in my 401k and comparing to Vanguard's Total Stock Market (VTSAX) - turnover is 19% at SSgA and 3.2% at Vanguard. Second eye-catcher is that SSgA's 3rd largest holding is some sort of futures contract - so this looks more like an actively managed index fund!

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Re: Will Indexing Kill the Market?

Post by Clever_Username » Thu May 02, 2013 12:20 am

C8H18Engineer wrote:I was looking at my one index fund (SSgA S&P 500) in my 401k and comparing to Vanguard's Total Stock Market (VTSAX) - turnover is 19% at SSgA and 3.2% at Vanguard. Second eye-catcher is that SSgA's 3rd largest holding is some sort of futures contract - so this looks more like an actively managed index fund!
How can a stock market index fund hold a futures contract?
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Re: Will Indexing Kill the Market?

Post by talzara » Thu May 02, 2013 12:35 am

Scooter57 wrote:The indexing they are talking about isn't just the total stock market. But when SPY is the most heavily traded security every day for months, and when other popular ETFs are the focus of option buying in huge amounts the fact so many stocks are being bought and sold as a unit might become significant.
Most of the trading consists of ETF shares changing hands. The underlying stocks stay together inside the ETF, and do not hit the open market.

Only if the ETF price departs significantly from the index do the Authorized Participants get involved, and start trading the underlying stocks. This happens if there is a net inflow or outflow -- in which case it's supposed to trigger buying/selling of the underlying stocks.

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Re: Will Indexing Kill the Market?

Post by G-Money » Thu May 02, 2013 12:44 am

Clever_Username wrote:
C8H18Engineer wrote:I was looking at my one index fund (SSgA S&P 500) in my 401k and comparing to Vanguard's Total Stock Market (VTSAX) - turnover is 19% at SSgA and 3.2% at Vanguard. Second eye-catcher is that SSgA's 3rd largest holding is some sort of futures contract - so this looks more like an actively managed index fund!
How can a stock market index fund hold a futures contract?
It's not uncommon. From Vanguard TSM's Investment Policy:
To track its target index as closely as possible, the fund attempts to remain fully invested in stocks. To help stay fully invested and to reduce transaction costs, the fund may invest, to a limited extent, in derivatives. Generally speaking, a derivative is a financial contract whose value is based on the value of a financial asset (such as a stock, bond, or currency), a physical asset (such as gold), or a market index (such as the S&P 500 Index). The fund will not use derivatives for speculation or for the purpose of leveraging (magnifying) investment returns.
I believe (although I never checked) that this language is included in every Vanguard fund's investment policy.

A quick look at the TSM annual report shows that TSM did have some futures contracts and swaps, although nowhere near as much as what C8H18 reports is in SSgA. See pages 24-27 here: https://personal.vanguard.com/funds/rep ... 2210073202
Don't assume I know what I'm talking about.

talzara
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Re: Will Indexing Kill the Market?

Post by talzara » Thu May 02, 2013 1:01 am

Clever_Username wrote:
C8H18Engineer wrote:I was looking at my one index fund (SSgA S&P 500) in my 401k and comparing to Vanguard's Total Stock Market (VTSAX) - turnover is 19% at SSgA and 3.2% at Vanguard. Second eye-catcher is that SSgA's 3rd largest holding is some sort of futures contract - so this looks more like an actively managed index fund!
How can a stock market index fund hold a futures contract?

Last annual report shows that State Street has put about 2.7% of the fund into S&P 500 futures contracts (notional value). That's not active management, in the usual sense of stock-picking, because they're not picking stocks -- they're sticking to the S&P 500.

Vanguard uses futures contracts, but to a much lesser extent. Vanguard does it because the mutual fund shares are redeemable for cash. Thus, they prefer to keep a certain amount of cash available at all times, so that they can pay out redemptions with cash on-hand, rather than by selling shares. The futures contracts allow them to remain fully-invested despite the cash balance. (It's easier to sell a single futures contract, rather than all 500 stocks separately.)

State Street, I have no idea what they're doing. They're an ETF, so they don't have to redeem for cash. They're not really doing enhanced indexing, because that usually involves putting the entire notional value of the fund into futures. Compared to that, 2.7% is nothing.

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Re: Will Indexing Kill the Market?

Post by umfundi » Thu May 02, 2013 2:40 am

Thread title should be: "Moving on to the the Next Excuse".

From a friend who says of some of his colleagues: "I can't really get them to change, but I can force them on to their next excuse."

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Re: Will Indexing Kill the Market?

Post by NightOwl » Thu May 02, 2013 3:05 am

I guess I'll post my usual reply: do you guys know a bunch of other people in real life who index?

I don't.

I'm the only person I know who owns mutual funds as opposed to single stocks. I routinely get made fun of for owning any bonds at all -- don't I know that they are guaranteed to return less than stocks?.

If you guys know these people who are going to index the free market into oblivion, you're obviously hanging out with a classier crowd than I am.

NightOwl
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Re: Will Indexing Kill the Market?

Post by nisiprius » Thu May 02, 2013 7:06 am

Scooter57 wrote:The indexing they are talking about isn't just the total stock market.
No, but the indexing I use myself is. Why should I care about frontrunning the S&P 500 or the Wilshire or some other index Vanguard used twenty years ago? "Attack indexing by attacking the S&P 500" is a good ploy, but it's not valid.
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Re: Will Indexing Kill the Market?

Post by Clever_Username » Thu May 02, 2013 10:11 am

Thanks for the explanations about futures contracts. I guess I should pay more attention to the prospectus.
"What was true then is true now. Have a plan. Stick to it." -- XXXX, _Layer Cake_

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