Money Pours In = Diminishing Returns?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
slowmoney
Posts: 167
Joined: Tue Dec 28, 2010 4:41 pm
Location: Louisiana Purchase

Money Pours In = Diminishing Returns?

Post by slowmoney » Wed Jun 21, 2017 7:25 pm

Nope. Not for index funds.

Money has been pouring, I mean pouring, into index funds. YET, index returns have not suffered diminishing returns.

Yep, it’s all rainbows. That billionth dollar in index funds is just as good as the first. No diminishing returns. :moneybag

On the other hand, as an active management fund increases in size, the returns always tank. TANK! They have to intentionally keep the fund very, very small to keep up the returns. That sucks.

Basically, the market if very efficient and an active fund can only mine so much excess return before it is completely exhausted. It is called diminishing marginal returns.

BUT index funds do not suffer from diminishing marginal returns. Indexing has gone from 0% to around 35% of the market and YET, they still track index returns! Nothin’ but rainbows.

If an active strategy was 35% of the market. Tanksville!! How do you compete with something that does not have diminishing marginal returns? :oops:

To be fair, in the overall market context, indexing does has diminishing marginal returns. If the market was 100% index it would not work as Bogle has stated. It seems that 20% to 30% would need to be active to establish a functioning price discovery that would keep the market efficient. But until then, bring on the rainbows!

Anyway, as an indexer, I thought this was hilarious. Maybe I am missing something, thoughts?
Information is more valuable sold than used. - Fischer Black (1938-1995)

User avatar
Taylor Larimore
Advisory Board
Posts: 27507
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Asset Bloat

Post by Taylor Larimore » Wed Jun 21, 2017 7:40 pm

slowmoney:

You are talking about "asset bloat." This is what Investopedia has to say on the subject:
So-called "asset bloat" is not much of a problem for bond, index and money market funds, which generally operate in large market segments that are very liquid and are less affected by large block trading transactions. With these funds, bigger is actually better because expenses can be spread over more investment assets.

However, if a managed stock fund gets flooded with new money, the investment managers may find it difficult to invest it in an efficient manner. As fund assets rise, the number of appropriate new stock prospects shrink and transaction costs increase, which makes maintaining the fund's investment style difficult.
Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

slowmoney
Posts: 167
Joined: Tue Dec 28, 2010 4:41 pm
Location: Louisiana Purchase

Re: Money Pours In = Diminishing Returns?

Post by slowmoney » Wed Jun 21, 2017 8:28 pm

Taylor wrote:
You are talking about "asset bloat."
Thanks Taylor. Yes. I find it rewarding that index funds don't have to worry about "asset bloat" but active managers certainly do. Seem like a difficult road for active management. Another hurdle to cross on the path to out performance.
Information is more valuable sold than used. - Fischer Black (1938-1995)

gtwhitegold
Posts: 220
Joined: Fri Sep 21, 2012 1:55 pm

Re: Money Pours In = Diminishing Returns?

Post by gtwhitegold » Sat Jun 24, 2017 11:12 pm

I would argue that as more money flows in, the expected returns will naturally decrease, but this is to be expected. However, if investing in market weighted indices, investors should just accept this and move on. Trying to outsmart the system is likely a fool's errand.

staythecourse
Posts: 6118
Joined: Mon Jan 03, 2011 9:40 am

Re: Asset Bloat

Post by staythecourse » Sat Jun 24, 2017 11:56 pm

Taylor Larimore wrote:slowmoney:

You are talking about "asset bloat." This is what Investopedia has to say on the subject:
So-called "asset bloat" is not much of a problem for bond, index and money market funds, which generally operate in large market segments that are very liquid and are less affected by large block trading transactions. With these funds, bigger is actually better because expenses can be spread over more investment assets.

However, if a managed stock fund gets flooded with new money, the investment managers may find it difficult to invest it in an efficient manner. As fund assets rise, the number of appropriate new stock prospects shrink and transaction costs increase, which makes maintaining the fund's investment style difficult.
Best wishes.
Taylor
As most of the time Taylor is correct. Even if a manager is the next great thing once folks find out and his AUM increase the market impact makes future alpha difficult to maintain. That is why it is SO IMPORTANT for active investorx to view the returns of the funds on a dollar weighted vs. time weighted return.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

User avatar
JoMoney
Posts: 6105
Joined: Tue Jul 23, 2013 5:31 am

Re: Money Pours In = Diminishing Returns?

Post by JoMoney » Sun Jun 25, 2017 1:41 am

slowmoney wrote:...If an active strategy was 35% of the market. Tanksville!! ...
I don't think it's quite as bad as " Tanksville!! " might imply, but it would make it likely that the strategy itself would be moving the market, it would be 'the market' (or more than 1/3rd of it).... and over time the fees being paid for the active management (but no 'above market' performance) could be pretty brutal.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

NibbanaBanana
Posts: 224
Joined: Sun Jan 22, 2017 10:34 pm

Re: Money Pours In = Diminishing Returns?

Post by NibbanaBanana » Sun Jun 25, 2017 8:15 am

Take a look at a chart of the Wellington fund vs the Balanced Index fund from 1998 on.
http://quotes.morningstar.com/chart/fun ... ture=en-US
Looks to me like the index fund got caught up in the TMT bubble of 2000 to some extent and suffered for it. Maybe the folks at Wellington management avoided those TMT bubble stocks and came through a lot cleaner. And over just about any period that I'm looking at, VWELX seems to perform better than VBINX even though it has pretty huge AUM.

I'm mostly in index funds myself, but I have to say that VG has some really good active funds. My guess is that an experienced manager can outperform an index but the fund has to be overseen by directors who are responsible, and only responsible to the shareholders. Vanguard is unique in it being the only true "mutual" fund company. Some VG better performing funds are closed now so probably true WRT AUM. But those folks running the Wellington fund seem to have it down regardless of AUM. Just interesting.

inbox788
Posts: 5647
Joined: Thu Mar 15, 2012 5:24 pm

Re: Money Pours In = Diminishing Returns?

Post by inbox788 » Sun Jun 25, 2017 12:29 pm

gtwhitegold wrote:I would argue that as more money flows in, the expected returns will naturally decrease, but this is to be expected. However, if investing in market weighted indices, investors should just accept this and move on. Trying to outsmart the system is likely a fool's errand.
I disagree. You presume the fund is making above average expected return. Many funds make average to below average expected returns (i.e closet index funds and underperforming active funds). For the latter, as money pours in and they place new monies in more average expected return investments, the expected return may actually increase! It's like a failing student who gets a C on an exam that raises his average. So yes, for the A student, each exam that he doesn't get an A will lower his average, but for the average C student, things don't change much.

gtwhitegold
Posts: 220
Joined: Fri Sep 21, 2012 1:55 pm

Re: Money Pours In = Diminishing Returns?

Post by gtwhitegold » Sat Jul 08, 2017 5:05 am

No, I'm arguing about markets in general. If assets continue to attract more money and prices continue to increase without reason or if they overreact to information and go significantly above historical valuations, then investors should expect lower returns in the future. I'm not supporting market timing and active management however.
inbox788 wrote:
gtwhitegold wrote:I would argue that as more money flows in, the expected returns will naturally decrease, but this is to be expected. However, if investing in market weighted indices, investors should just accept this and move on. Trying to outsmart the system is likely a fool's errand.
I disagree. You presume the fund is making above average expected return. Many funds make average to below average expected returns (i.e closet index funds and underperforming active funds). For the latter, as money pours in and they place new monies in more average expected return investments, the expected return may actually increase! It's like a failing student who gets a C on an exam that raises his average. So yes, for the A student, each exam that he doesn't get an A will lower his average, but for the average C student, things don't change much.

User avatar
packer16
Posts: 1044
Joined: Sat Jan 04, 2014 2:28 pm

Re: Money Pours In = Diminishing Returns?

Post by packer16 » Sat Jul 08, 2017 7:12 am

I think it depends upon how much undervaluation a manager can find & invest in at a given time. It is very difficult in the large cap US space to do better because of the competition. However, in niches you can find bargains. These have a tendency to be places that cannot handle alot of funds (smaller companies with not alot of trading volume) & for the most part require permanent capital to exploit. The other characteristic of firms that are undervalued is they typically all appear in the same or similar industry groups at a given time so attempting to find a diversified group of undervalued firms at any one is impossible except for times of panic.

Another key to getting these returns is to find an investor base who is also patient (a very hard thing to do) or do it yourself. I have used a DIY approach which has worked thusfar in part because I am so small. One area that active appears to do better in is global or as in Wellington's case balanced funds. It appears there is more alpha across traditional asset classes than within each class & the alpha can be achieved at the security level versus the asset level.

Another area where I think you see diminishing returns is bonds. Lots of money is looking for a safe return and the demographic trends would say that this will continue going forward. IMO opinion what you are seeing in bonds is something that most folks who have a modest risk tolerance can exploit by either investing more in stocks or other alternatives with reasonable fees (NNN real estate, income producing infrastructure funds or ship leasing company that pay high dividends). I am a contrarian by nature so I use bonds only for funds in need to spend in the next few years that I will not receive from wages & invest what would normally be in the bond bucket in more equity or alternatives with reasonable fees. I know this flies in the face of the need, ability & willingness to take risk approach but I think that approach is most applicable to risk averse folks and less risk averse you are the less applicable it is. Just my 2 cents.

Packer
Buy cheap and something good might happen

Post Reply