Do Index Funds Distort Market Valuations?

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Simplegift
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Do Index Funds Distort Market Valuations?

Post by Simplegift » Sun Jul 16, 2017 12:08 pm

One criticism that's been leveled at cap-weighted index funds, especially since becoming so popular, is that they increase the mis-valuation of the market by making overvalued stocks more overvalued and undervalued stocks more undervalued. A recent three-page article succinctly opines why this cannot be true. A few key points from the article, not always understood even by index fund investors (myself included):

• The holdings of active managers, in aggregate, must be in proportion to market-cap weights.
  • As William Sharpe pointed out in his seminal article, “The Arithmetic of Active Management,” the total market portfolio and the portfolio of indexers are both capitalization-weighted — and thus it's inescapable that active managers collectively have to be market cap-weighted as well (chart below).

    Image
    Source: Journal of Portfolio Mgmt.
• An index fund can be purchased: (1) with fresh money, or (2) from sale of an actively-managed holding.
  • (1) When buying an index fund with fresh money (say, from a paycheck), either the seller is an indexer too, in which case the whole index as a package changes hands, or the seller is a collection of active managers, who are collectively market cap-weighted.
    (2) When investors decide to sell their actively-managed holdings and move into an index fund, there is no net impact on valuations, since active managers in aggregate are market-cap weighted as well.
Personally, I've never looked at the stock market from this perspective — though it seems quite obvious — and am not yet sure I understand all the ramifications of this view. It would seem not to apply to narrow sector funds and ETFs, but just to the broad market indexes. Your thoughts?
Last edited by Simplegift on Sun Jul 16, 2017 1:01 pm, edited 2 times in total.
Cordially, Todd

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Re: Do Index Funds Distort Market Valuations?

Post by BuyAndHoldOn » Sun Jul 16, 2017 12:59 pm

I wish I could find it, but there was a Wall Street Journal article a while back that discussed the valuation metrics of companies in the S&P 500 vs. outside the S&P 500. I believe they used two trucking/transport companies as an example, pointing out that the company included in the index had a higher P/E multiple relative to the excluded company. This could have been a cherry-picked example; more research would be needed.

I think for indexes that are not a representative sample of the entire market - say, a sector fund, or even the S&P 500 itself - in and of themselves, they are a market distortion (so to speak). Sort of like any other "active bet", actually. If investors [in mass] flock to such funds, then certain stocks that are most widely held will be more widely held (Etc.). But: the market knows this, and active participants can act accordingly. So maybe there is no such problem.

But for a total market fund, I don't think that type of "asset bloat" is as serious of a concern. And there are still enough active participants in the market to set prices and sell stocks that are "over valued".

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Re: Do Index Funds Distort Market Valuations?

Post by Simplegift » Sun Jul 16, 2017 3:59 pm

BuyAndHoldOn wrote:I think for indexes that are not a representative sample of the entire market - say, a sector fund, or even the S&P 500 itself - in and of themselves, they are a market distortion (so to speak). Sort of like any other "active bet", actually. If investors [in mass] flock to such funds, then certain stocks that are most widely held will be more widely held (Etc.). But: the market knows this, and active participants can act accordingly. So maybe there is no such problem.
From the few studies I've seen, there does appear to be an impact on stock prices of S&P 500 companies when they first gain entry to or drop out of the index. But this effect seems to be short-lived and prices subsequently revert to "normal" after a few weeks. From a McKinsey and Co. study:
McKinsey & Co. wrote:To determine whether or not index inclusion made a difference, we estimated the abnormal stock returns over an 80-day test period (from 20 days before the effective date of inclusion to 60 days after). Clearly, the best measure of abnormal
returns is whether the new entrants enjoy a pattern of lasting positive returns, driven by the inclusion itself. This was clearly not the case.

Indeed, although abnormal returns in the ten days prior to the effective date did amount to a maximum average around 7 percent and a median around 5 percent, they returned to zero within 45 days after the effective date. In terms of statistically significant positive returns, the effect disappears even sooner—after a mere 20 days.
This is just one study, but I'm sure there's been a ton of other research around these questions. As you suggest, more interesting would be to see the long-term impacts of indexing on specific, narrow sectors of the market (such as REITs, energy stocks, other industry sector ETFs) — if these impacts exist at all.
Last edited by Simplegift on Sun Jul 16, 2017 4:18 pm, edited 1 time in total.
Cordially, Todd

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Re: Do Index Funds Distort Market Valuations?

Post by pkcrafter » Sun Jul 16, 2017 4:17 pm

One criticism that's been leveled at cap-weighted index funds, especially since becoming so popular, is that they increase the mis-valuation of the market by making overvalued stocks more overvalued and undervalued stocks more undervalued.
Sour grapes. This doesn't make any sense to me. Was the market never overvalued before index funds? Who shapes the market? Active investors looking for opportunities, that's who. If there are stocks that are mis-valued on the high side, active investors can sell them and buy the ones that are mis-valued on the low side.

When the market is showing profit, both pro investors and retail investors buy funds or stocks, and then they binge buy all the leading stocks, thus pushing valuations up. No index fund needed. We are experiencing this right now. But don't worry, this to shall pass. :happy In the meantime, those losing money because of index funds can stop whining.

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Re: Do Index Funds Distort Market Valuations?

Post by Hawaiishrimp » Sun Jul 16, 2017 4:19 pm

I probably shouldn't say it but I'm going to anyway:

I don't really care.
I save and invest my money, so money can make money for me, so I don't have to make money eventually.

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Re: Do Index Funds Distort Market Valuations?

Post by Phineas J. Whoopee » Sun Jul 16, 2017 8:12 pm

What is the external-to-the-market definition, determination, or calculation, of over- and under-valued? Unless there's a market-external authority the words are meaningless.

Naturally, most market participants disagree with each other about appropriate security prices most of the time. That's because they have different desires, motivations, and practical circumstances. See the middle portion of the link for more details.

There aren't, and can't be, perfect prices. The basis of commerce is different people value the same thing differently at the same time. If they didn't, see the link, trade would come to a halt.

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Re: Do Index Funds Distort Market Valuations?

Post by pkcrafter » Sun Jul 16, 2017 8:23 pm

Phineas J. Whoopee wrote:What is the external-to-the-market definition, determination, or calculation, of over- and under-valued? Unless there's a market-external authority the words are meaningless.

Naturally, most market participants disagree with each other about appropriate security prices most of the time. That's because they have different desires, motivations, and practical circumstances. See the middle portion of the link for more details.

There aren't, and can't be, perfect prices. The basis of commerce is different people value the same thing differently at the same time. If they didn't, see the link, trade would come to a halt.

PJW
Yes, this is what makes markets. :idea:

Those complaining have the entire market to choose from, so why don't they pick their stocks and beat the index?

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Re: Do Index Funds Distort Market Valuations?

Post by triceratop » Sun Jul 16, 2017 8:24 pm

Phineas J. Whoopee wrote:What is the external-to-the-market definition, determination, or calculation, of over- and under-valued? Unless there's a market-external authority the words are meaningless.

Naturally, most market participants disagree with each other about appropriate security prices most of the time. That's because they have different desires, motivations, and practical circumstances. See the middle portion of the link for more details.

There aren't, and can't be, perfect prices. The basis of commerce is different people value the same thing differently at the same time. If they didn't, see the link, trade would come to a halt.

PJW
Very true. At the same time I like Todd's chain of logic because it shows even if you take the premise of those saying index funds distort valuations, the conclusion by the precise same logic is that active funds do just as well. I love logical arguments of this sort, I just want to put a bow on it. It's perfect.
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Re: Do Index Funds Distort Market Valuations?

Post by nisiprius » Sun Jul 16, 2017 8:51 pm

"Indexing is a fad and all fads distort the market. If everyone runs to one side of the boat, the boat lists, founders, and sinks."

"But indexing means that everyone runs to the center of the boat."

"Uh... well... if too many people climb in the boat and go to the center, the boat will have less and less freeboard and it will sink."

"Yes, but that's because too many people climbed in the boat, not because they all went to the center. It would be worse if they did anything else."
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: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Mon Jul 17, 2017 1:04 am

Simplegift wrote: • The holdings of active managers, in aggregate, must be in proportion to market-cap weights.
This one doesn't work. It forgets about control investors who can hold stock, add stock and destroy stock.
Monday company X has 1m shares held in proportion to the market-cap weight.
Tuesday company X doubles the number of shares and gives 1m of them to a fully owned subsidiary. The subsidiary gives them to a bank as collateral against a loan that will be repaid. That doubles the float. The green line shrinks to 1/2 its size. The indexers now have to buy double their previous holdings, doubling the size of your green line. Which comes from the orange, grey, yellow, blue...

Nothing actually happened but an accounting gimmick unless the subsidiary defaults. So what is the right size for the green line?

My thought in general to steal a line I used on another thread is that this is investing equivalent of a physicist a f a out a solution for a spherical horse on a frictionless planet. It is much easier to work out the CAPM theory by excluding investors who have different objectives than passive minority shareholders whose sole source of aggregate value is the discounted value of future dividends. It worked well when indexing was just another form of passive minority shareholding. As indexing (at least for the SP500) has become so dominant the model starts to fall apart since the other classes that can normally be ignored start to play a substantial role.

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Re: Do Index Funds Distort Market Valuations?

Post by Simplegift » Mon Jul 17, 2017 9:43 am

jbolden1517 wrote:It is much easier to work out the CAPM theory by excluding investors who have different objectives than passive minority shareholders whose sole source of aggregate value is the discounted value of future dividends. It worked well when indexing was just another form of passive minority shareholding. As indexing (at least for the SP500) has become so dominant the model starts to fall apart since the other classes that can normally be ignored start to play a substantial role.
I’m not doubting that the stock market is more complex than the simplistic model suggested in the OP. However, I’m curious about the magnitude of the market capitalization that is held by investors with “different objectives” as you say — that is, whose source of aggregate value is NOT the discounted value of future dividends.

In other words, if we accept that 40% of the market today is held passively (by index funds and ETF investors), what’s the proportion of the remaining 60% that is held by these “other classes” of investors with these “different objectives”? And exactly how do these "other classes" of investors create problems for CAPM theory today, now that indexing is becoming so widespread? Appreciate your insights.
Cordially, Todd

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Mon Jul 17, 2017 7:18 pm

Simplegift wrote:
jbolden1517 wrote:It is much easier to work out the CAPM theory by excluding investors who have different objectives than passive minority shareholders whose sole source of aggregate value is the discounted value of future dividends. It worked well when indexing was just another form of passive minority shareholding. As indexing (at least for the SP500) has become so dominant the model starts to fall apart since the other classes that can normally be ignored start to play a substantial role.
I’m not doubting that the stock market is more complex than the simplistic model suggested in the OP. However, I’m curious about the magnitude of the market capitalization that is held by investors with “different objectives” as you say — that is, whose source of aggregate value is NOT the discounted value of future dividends.

In other words, if we accept that 40% of the market today is held passively (by index funds and ETF investors), what’s the proportion of the remaining 60% that is held by these “other classes” of investors with these “different objectives”?
I'll start by not accepting the number for the SP500 which is where I think the problem is.

Both BankofAmerica/Merrill and JPMorgan using wildly different metrics (and thus independently testing) put the level at around 70% for the SP500.
Bank of America counted indexing the SP500, indexing that ends up looking like the SP500 in combination (TSM, Vanguard Value and Vanguard Growth in combination), quasi indexing (widely diversified funds that end up tracking the SP500 closely)... BankofAmerica claimed the next biggest group for was quantitative value (they included active funds that use simple metrics). Obviously those guys don't hold high P/E SP500 stocks. For that group they believed that there was already heavy float manipulation which was setting prices (and pretty much said BofA was open for business to help companies who are high P/E SP500 stocks do this). Their position was because of this dynamic the type of research they and other large investment houses provide (6-18 mo earnings outlook) which should be the dominant factor for these stocks had become essentially worthless for predicting share prices on high P/E SP500 stocks. So at least in BofA's opinion those stocks (high P/E SP500) were no longer are in any sense tied to any fundamental at all for investors with an 18mo time horizon. They were advising their clients to get out of the middle and let the indexers and the control investors go head-to-head. I think that's pretty stark, whether you agree or disagree.

JPMorgan put the ratios on daily volume for the SP500 at 3/7th indexers/passive, 3/7 arbitrage, 1/7th fundamental. So pretty much on daily trades they think it is the arbitrage guys vs. the indexers/passive with everyone else being bit players.
Simplegift wrote:And exactly how do these "other classes" of investors create problems for CAPM theory today, now that indexing is becoming so widespread? Appreciate your insights.
Control investors aren't minority passive investors pretty much by definition. They can be making money from a company lots of ways other than dividends and the stream of future dividends. So their pricing of a stock may reflect opportunities other than what CAPM envisions. For example a control investor who also owns a building that would make a good headquarters for company X might use his influence to sell the building. M&A activity is a wonderful and well known chance to pull money sideways. That sort of stuff has always been happening though. But as indexing become an ever greater share of the market control investors become important because their fraction of "the rest" rises.

The real problem for indexers is float manipulation. If 70% of a stock's float is going to be bought regardless of price it becomes incredibly profitable for a company to create float and sell shares to index funds (I'm including quasi-indexing and passive here) as a way to use index funds as a cheap source of financing. In a normal market, in CAPM's theory investors are rationally pricing stocks based on their future discounted dividends using a discount rate that adjusts for risk. So under CAPM doubling the number of shares merely cuts the share price in half. Doubling the number of shares should have no impact on market cap. But of course index funds don't rationally evaluate the future stream of dividends. Indexers hold a constant portion of any stock, buying or selling based on float not dividend prospects. So when the number of shares double they have to slowly raise they buy target till they get the shares back in balance. This is the same thing that happens to short investors in a short squeeze. They will end up paying far more than the company is worth. Just imagine a stock with a P/B of 5 doubling its number of shares. The indexers go from holding 70% to 35% and thus have to buy 1/3 of the company or 2/3rds of the new float. If the P/B stays constant (doubtful the control investors would be quite that greedy but it explains the principle) that means the indexers end up with the same 70% of the assets and also a large cash position the paid $5 for every $1 of.

Now that cheap financing benefits the company and the passive investors own 70% of the company. So 70% of the lost $4 is going from their right pocket to the left pocket the same as if the index fund had directly written a loan to the company and then written the loan off. But the remaining $1.20 just fell on the floor. Its going to go to control investors, other investors, short sellers... That drain is huge. All this can be completely above board and disclosed because indexes don't read prospectus or PR statements. Companies can tell investors openly they are manipulating their float to squeeze index funds and the index funds still buy. Something similar to this happened for a decade (and arguably is still happening) to VPACX. I don't think this is a threat that should be taken nearly so lightly by Bogleheads. Do you really want to be in the business of funding negative interest bonds to SP500 high P/E stocks?

In short CAPM assets that investors are setting stock prices to rationally maximize their risk adjusted return. The biggest investor in high PE SP500 stocks aren't doing that. That investor is only interested in holding a fixed percentage of the float. When index funds were a minority this conflict didn't matter. Now quite obviously we are at a point it does.
Last edited by jbolden1517 on Mon Jul 17, 2017 8:39 pm, edited 1 time in total.

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Re: Do Index Funds Distort Market Valuations?

Post by Simplegift » Mon Jul 17, 2017 8:11 pm

^^^ Thank you for taking the time to reply in detail. You’ve raised several concepts that are new to me, and I’d like to think these over and research them in a little more depth. To this end, if they’re available online and not proprietary, are you able to link to the Bank of America and JP Morgan studies you referenced above?

The idea of control investors who can hold stock, add stock and destroy stock is something I need to wrap my mind around — and if they have a sufficiently large impact on market pricing, understand exactly how they violate William Sharpe’s model of the cap-weighted total market in the OP. You given me a few things to think over! Thanks.
Cordially, Todd

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Re: Do Index Funds Distort Market Valuations?

Post by David Jay » Mon Jul 17, 2017 9:14 pm

Simplegift wrote:The idea of control investors who can hold stock, add stock and destroy stock is something I need to wrap my mind around — and if they have a sufficiently large impact on market pricing, understand exactly how they violate William Sharpe’s model of the cap-weighted total market in the OP. You given me a few things to think over! Thanks.
Control investors holding stock is one reason why indexes use free float cap weighting. Those holdings are not traded and thus are not included in the target cap weighing of the index fund.
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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Mon Jul 17, 2017 9:24 pm

Simplegift wrote:^^^ Thank you for taking the time to reply in detail. You’ve raised several concepts that are new to me, and I’d like to think these over and research them in a little more depth. To this end, if they’re available online and not proprietary, are you able to link to the Bank of America and JP Morgan studies you referenced above?

The idea of control investors who can hold stock, add stock and destroy stock is something I need to wrap my mind around — and if they have a sufficiently large impact on market pricing, understand exactly how they violate William Sharpe’s model of the cap-weighted total market in the OP. You given me a few things to think over! Thanks.
Well the good news for TSM investors is however bad it is in stocks it is far worse in bonds. Barclay's indexed funds (Total Bond Market is one of these BTW) + banks doing forced buys + central banks are $21 trillion. That's $21 trillion that doesn't care about pricing or value. The distortion became so bad that several government issued bonds sold with negative interest rates and they sold. That's on top of bonds selling at a premium so high they have negative yield. Think about that for a second. We've had bonds since about the 13th century. In that long history no investor ever bought one of these bonds mathematically guaranteed to underperform stuffing money in a mattress. Yet until we had about a year where these negatively yielding bonds were being bought (http://www.cnbc.com/2016/06/29/there-ar ... ields.html)

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Mon Jul 17, 2017 9:36 pm

David Jay wrote:
Simplegift wrote:The idea of control investors who can hold stock, add stock and destroy stock is something I need to wrap my mind around — and if they have a sufficiently large impact on market pricing, understand exactly how they violate William Sharpe’s model of the cap-weighted total market in the OP. You given me a few things to think over! Thanks.
Control investors holding stock is one reason why indexes use free float cap weighting. Those holdings are not traded and thus are not included in the target cap weighing of the index fund.
Your confusing two different things.
  1. The holdings of control investors
  2. The float created by control investors having the company itself create new float
The holdings of control investors don't count as float. So I agree with you that (a) is not float as far as the index fund is concerned. But (a) and (b) aren't the same thing. To use the cheap equity financing provided by index funds the company, not the control investor, issues the new float. The control investors have a fiduciary obligation to make sure the new equity is sold at a fair price. Since these are high P/E stock selling to an investor acting like he's caught in a short squeeze and thus overpaying this obligation is easily met. The company obviously benefits from selling stock to such an investor. The control investors have an obligation not to defraud new investors but they aren't. This investor doesn't care why there was an increase in float.

Since the original article was from BofA let's use them as an example. The company could borrow money from BofA and give BofA shares as collateral. Those shares are no longer held by the company so they become float. Index funds respond by buying and buying and buying driving up the price. The company can sell new equity (creating even more float) to fulfill this demand. Any dividends paid to the shares at BofA would be "interest" on the "loan".

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Re: Do Index Funds Distort Market Valuations?

Post by Simplegift » Mon Jul 17, 2017 9:41 pm

jbolden1517 wrote:Since the original article was from BofA let's use them as an example.
Can you provide any links to the original Bank of America and JPMorgan studies that you referenced upthread? Sounds like they'd be interesting and insightful reads. Thanks.
Cordially, Todd

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Mon Jul 17, 2017 9:58 pm

Simplegift wrote:
jbolden1517 wrote:Since the original article was from BofA let's use them as an example.
Can you provide any links the original Bank of America and JPMorgan studies that you referenced upthread? Sounds like they'd be interesting and insightful reads. Thanks.
I wish I could. Its proprietary. Author of the BofA report was Savita Subramanian. You can see quotes about it and from it all over the web though.
JPMorgan I don't know where the original came from but for example: http://www.cnbc.com/2017/06/13/death-of ... mates.html

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Re: Do Index Funds Distort Market Valuations?

Post by Dirghatamas » Mon Jul 17, 2017 10:02 pm

jbolden1517 wrote: The real problem for indexers is float manipulation. If 70% of a stock's float is going to be bought regardless of price it becomes incredibly profitable for a company to create float and sell shares to index funds (I'm including quasi-indexing and passive here) as a way to use index funds as a cheap source of financing.
jbolden1517
First, it is great to have dissenting views, otherwise any group can start sounding like an echo chamber. On this site, indexing is considered so self evident (I completely agree with the pro indexing view) that any different views are quickly shot down. For good discussions, one should take the other point of view and argue against oneself..it is healthy.

For the record, I have been a passive indexer in the true sense (100% world stock index) for my entire investing life of 25 years, so I obviously believe Indexing DOESN'T distort market valuations.

Now, for your comments, I don't get them. At any time a company can decide to go public (IPO) or go private. It can issue debt for future investments. It can issue new shares (share dilution) or buyback shares. It can buy other companies or be bought out by M&A. So, the people in charge, Board of Directors, CEO/CFO, your "control investors" are constantly evaluating many of these options and picking the one which makes most sense to them. So what?

The number of shares is not some material thing, it has to be evaluated (and is) in context of the whole assets-liabilities. We routinely have share buyback and share dilutions. They don't change the total market cap of a company, they simply change the % of each company a share entitles you to..

Share dilution is not an indexing phenomenon but typically associated with fast growing economies. Share dilution in emerging markets has been perhaps the biggest reason why investors didn't achieve huge returns. There was hardly any indexing in those markets for much of this time..China has perhaps the biggest %share dilution in any major market over the last 30 years and yet Chinese stock market wasn't represented to market value in western index funds..

I understand your point that companies can issue shares/share dilution but I don't see what that has to do with indexing?

PS: The total number of outstanding shares in the US total stock market is DECREASING not INCREASING over the last decade.

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Re: Do Index Funds Distort Market Valuations?

Post by Dirghatamas » Mon Jul 17, 2017 11:04 pm

I wanted to share hard data, not just opinion. On the subject of total number of shares, jbolden1517 is pointing out that companies in S&P500 can use it (indexing) to raise money cheaply so they will dilute shares.

Here is the actual data on the total shares in underlying companies in the S&P500.
https://insight.factset.com/hubfs/Buyba ... _12.19.pdf

This is from Buyback Quarterly till the end of 2016. The actual rolling chart over time of total shares is on page 11.

Here is the relevant piece. Emphasis in bold is mine. So number of shares have been decreasing (as I said in earlier post), not increasing.
Share Count Decreases 1.7% Year-Over-Year
16% of S&P 500 Companies Reduced YOY Share Count by >5%
Aggregate shares outstanding for the S&P 500 index declined 1.7% year-over-year in the third quarter. The share
count at the end of Q3 represented the lowest share count for the index since Q1 2009
. Approximately 16% of S&P
500 companies reduced their share count by more than 5% in Q3 compared to the year-ago period. This marked a
decline from Q2 when 20% of the index decreased their shares outstanding by more than 5%.

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Tue Jul 18, 2017 5:38 am

Dirghatamas wrote: The number of shares is not some material thing, it has to be evaluated (and is) in context of the whole assets-liabilities. We routinely have share buyback and share dilutions. They don't change the total market cap of a company, they simply change the % of each company a share entitles you to..
You are correct that for most normal investors changing the market cap doesn't change their evaluation of the stock at all. If a company were to synthetically double their number of shares, it halves the earnings (or future dividends) for each share. An investor concerned about fundamentals and not concerned with tracking an index would be indifferent to the dilution the price per share would halve and thus the dilution would have no effect on the market cap. There is however a very large and very important group of investors that act like dilution is an extremely important event: Index funds, or other funds trying to track the index and not trading on fundamentals. Index funds don't evaluate the earning or the future dividends of the companies they buy. Their buy/sell determination is determined entirely by whether they do or do not hold an appropriate percentage of the company. When a company dilutes their shares, they are underweight the stock and so they respond by buying. For the SP500 index funds and quasi indexers are the dominant holders and buyers of their stock. So much so that their buys and sells mostly set market price. Which means a company with a high P/E can issue new equity and using the forced buying behavior of index funds to force that new equity to be sold at a very high price.

The argument for index funds was dependent on mutual funds and pension funds being able to set market price. The argument was that among passive minority shareholders indexing was the best strategy. As indexing has become more successful for SP500 stocks the other passive minority shareholders no longer set market price. That was what Bank of America was saying, the kind of research they do which is focused on 6-18 mo earning prospects, simply does not impact price any longer on the SP500 because the people trading the 6-18 mo earning prospects don't have the volume anymore. Earning matter over the long term, and those are being caught by value investors but the short term stuff that was the bread and butter of wall street trades doesn't work for the SP500.

Congratulations! You won the argument among passive minority shareholders, at least for the SP500.

The flows in and out of the SP500 index funds and quasi indexers are the dominant factor setting market price with other investors playing a secondary role. Indexers because they are now the major player in the passive minority shareholder class for SP500 stocks are being more directly confronted with counter strategies from those groups that don't have remotely similar buy/sell objectives. Bogleheads seem to focus obsessively on other mutual funds and the strategies they employ. They don't tend to think about market participants like arbiters, derivatives traders, control investors, hedge funds that don't have the objective of finding a good price on a stock and just sitting with for a relatively long period of time (say more than a few days). But now that they haver crushed the competition among mutual funds and pension funds those are the investors indexers are left competing for return with.
Dirghatamas wrote: PS: The total number of outstanding shares in the US total stock market is DECREASING not INCREASING over the last decade.
That's absolutely true. The number of listed companies is decreasing and we do have some M&A activity as well as buybacks. We have very cheap bond financing as well, Most companies are much better off borrowing inexpensively on the credit markets. They can't force index stock funds to buy equity at with an expected negative return, but they can get index bond funds to buy their bonds at a very maximum return.

The problems with indexing are far worse in the bond market.

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Re: Do Index Funds Distort Market Valuations?

Post by Dirghatamas » Tue Jul 18, 2017 3:18 pm

jbolden1517
You have an interesting theory (or more accurately, you say the big banks have this theory), but the facts don't seem to line up. For your theory to be correct, we should be seeing 1) Significant increase in share count of S&P500 companies as the mechanism by which this valuation distortion happens 2) Indexers should be significant % of total traded volume of stocks. If neither is true, you have to explain how your theory is backed by data.

1) Share count: As I already stated above, share count in S&P500 is on a long term decreasing trend. Source https://insight.factset.com/hubfs/Buyba ... _12.19.pdf

2) Indexers % of traded Stock Volume. According to Wikipedia data on US stocks market capitalization and average traded volumes https://en.wikipedia.org/wiki/List_of_stock_exchanges taking NYSE and NASDAQ as representative of US, the total traded volume per year was ~$32 trillions :shock: :shock:. In other words, it was more than the market cap itself. The number involved is ~1-2 orders of magnitude higher than the new money moving into index funds. So, it would appear that trading is dominated by day/short term traders rather than index funds. As such, the market price setters are short term active traders rather than index funds. This will not change even if index funds have 90% of total stocks because they trade very little.

So, those are my main facts as to why I am highly skeptical of your theory: stock shares are going down in numbers in US and the trading volume is order of magnitude higher than index funds.

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Tue Jul 18, 2017 6:18 pm

Dirghatamas wrote:jbolden1517
You have an interesting theory (or more accurately, you say the big banks have this theory), but the facts don't seem to line up. For your theory to be correct, we should be seeing 1) Significant increase in share count of S&P500 companies as the mechanism by which this valuation distortion happens 2) Indexers should be significant % of total traded volume of stocks. If neither is true, you have to explain how your theory is backed by data.
I was going to respond to your other post. You should be seeing an increase in shares from high P/E stocks that need financing. This trick doesn't work for all SP500 stocks and obviously doesn't apply to companies that don't need financing.

AAPL Apple Inc. was the biggest buyback and they have tons of cash as well as a very moderate P/E.
GE General Electric Company Industrials was looking at a stock slump boosted their dividend and bought back shares. P/E was around 20.
MSFT Microsoft Corporation Information Technology high profit margins P/E around 20 (again 2016)
GILD Gilead Sciences, Inc. Health Care P/E of 7
AIG American International Group, Inc. Financials P/E normally around 10. 4Q2016 they lost a ton.
MCD McDonald's Corporation Consumer Discretionary P/E around 20.
Indexers % of traded Stock Volume. According to Wikipedia data on US stocks market capitalization and average traded volumes https://en.wikipedia.org/wiki/List_of_stock_exchanges taking NYSE and NASDAQ as representative of US, the total traded volume per year was ~$32 trillions :shock: :shock:. In other words, it was more than the market cap itself. The number involved is ~1-2 orders of magnitude higher than the new money moving into index funds. So, it would appear that trading is dominated by day/short term traders rather than index funds. As such, the market price setters are short term active traders rather than index funds. This will not change even if index funds have 90% of total stocks because they trade very little.
Index funds make market, they frequently actively trade themselves for shares on the way in. It helps offset their trading losses from getting front run. I gave you the link to the quote from JPMorgan. Do you think JPMorgan is lying that much about the activity they are seeing?

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Re: Do Index Funds Distort Market Valuations?

Post by Dirghatamas » Tue Jul 18, 2017 11:23 pm

jbolden1517 wrote: I was going to respond to your other post. You should be seeing an increase in shares from high P/E stocks that need financing. This trick doesn't work for all SP500 stocks and obviously doesn't apply to companies that don't need financing.
Given that we are talking about TOTAL/ market cap weighted stock index funds not individual stocks or very narrow niche index, what matters is the aggregate. Like I said before in this thread, the # of shares in US total stock market (or S&P500 as close proxy) have been decreasing over the last decade while the shares in Total International have not. For the US specific case, your thesis (there is a lot of share dilution from indexing) is NOT true as can be verified by the total market shares. Why should we care if some individual companies are increasing shares as long as the aggregate of all of them (the index) is decreasing in shares. For passive index investors like me, what matters is the index level movement, not at the granularity level of each company.
jbolden1517 wrote: Index funds make market, they frequently actively trade themselves for shares on the way in. It helps offset their trading losses from getting front run. I gave you the link to the quote from JPMorgan. Do you think JPMorgan is lying that much about the activity they are seeing?
So I went and read your link. The link DOESN"T say what you think it says. A closer/skeptical read of the link is necessary.
Kolanovic estimates "fundamental discretionary traders" account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago, he said.
Fair enough. How does one jump from that to most trading is by index funds? If you read further in the link it says
A subset of quantitative trading known as high-frequency trading accounted for 52 percent of May's average daily trading volume of about 6.73 billion shares, Tabb said. During the peak levels of high-frequency trading in 2009, about 61 percent of 9.8 billion of average daily shares traded were executed by high-frequency traders.
So if passive + quants make up 60% and just high frequency portion of quants make up 52 percent, that leaves just 8% of trading volume to be shared by quants that are NOT high frequency traders + all passive index funds. This gels with what I wrote above that the total volume of traded stocks is at least 1 order and potentially 2 orders of magnitude higher than that traded by index funds. Basically the trading by passive index funds is a nit.

Instead of giving opinions (a Banks or your or mine), I already gave you the publicly available facts from both NYSE and NASDAQ showing trading volumes. The total trading volumes are 1-2 orders of magnitude higher than needed by index fund moneys..the obvious conclusion is that it is dominated by someone else, not index funds. You link says it is NOT dominated by fundamental/traditional trading. Fair enough. So it is dominated by Quant & HIgh Frequency Trading. So what? As long as it is NOT dominated by index funds, how can they cause market distortions.. You (or your link) haven't shown that index funds dominate trading volumes

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 6:13 am

Dirghatamas wrote:Given that we are talking about TOTAL/ market cap weighted stock index funds not individual stocks or very narrow niche index, what matters is the aggregate.
An investment strategy can bleed at particular points. 90% bonds + 10% betting black on roulette does worse than pure bonds because roulette bleeds off returns. The fact that in the aggregate this is still a positively returning portfolio doesn't change anything. I'm making the same argument you all make with regard to expense ratios and you are making the argument that was common that high ER didn't matter because the year to year returns of the market are much greater than the difference between a high and low ER. 150 basis points / yr in bleed won't overwhelm the year to year advantages of holding the USA economy. But it is a structural difference.

More importantly these are the early signs of how the market is responding to indexing. As index and passive become dominant forces and not just another market participants other market participants have to react to it. The type of analysis that only took into account other passive minority long term shareholders becomes less relevant and analysis needs to take into account investors who are not passive, are not minority, are not long term.

You incidentally also see the change in behavior in the other direction. For lower P/E stocks (especially SP500) buybacks are met by index (quasi index and other passive) selling. So the boost that buybacks 20 years accomplished isn't working as well today. Active traders noting this are exacerbating the effect of the indexes by shorting stocks as they approach the end of the wave of buybacks. Companies are responding by raising dividend payout ratios (a very good thing). http://topforeignstocks.com/wp-content/ ... -Ratio.jpg

Which is why when you looked at the buybacks from your own research you could see quite company specific reasons for their timing.
Dirghatamas wrote: Like I said before in this thread, the # of shares in US total stock market (or S&P500 as close proxy) have been decreasing over the last decade while the shares in Total International have not. For the US specific case, your thesis (there is a lot of share dilution from indexing)
That's not my thesis (or really Savita Subramanian's thesis). My thesis is that there is a problem in SP500 high P/E stocks not the market in general. So I'm specifically excluding most of the SP500 and the other 30% of TSM which is not SP500. Since you are agreeing share dilution and share buybacks occur reread Simplegift's original post (which again is not really his thesis this is standard CAPM). It is based on not considering these sorts of activities. Which is not unusual, up until recently those sorts of activities were things that in the aggregate and over the long term had no impact on passive minority shareholders.
Why should we care if some individual companies are increasing shares as long as the aggregate of all of them (the index) is decreasing in shares.
Because you can still bleed off assets at specific points because of specific problems.
Dirghatamas wrote: For passive index investors like me, what matters is the index level movement, not at the granularity level of each company.
A mutual fund is just a basket of individual companies. Bad assets in a basket are still bad assets. Holding 20% bad assets does less harm than if you were 100% invested in them but the harm doesn't magically disappear.

I'll hit your stuff on trading volumes later. The argument regarding dilution is more straight forward than how you are interpreting what JPMorgan said. And I have to start heading out.

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Re: Do Index Funds Distort Market Valuations?

Post by Simplegift » Wed Jul 19, 2017 8:49 am

jbolden1517 wrote:More importantly these are the early signs of how the market is responding to indexing. As index and passive become dominant forces and not just another market participants other market participants have to react to it.
jbolden1517 wrote:My thesis is that there is a problem in SP500 high P/E stocks, not the market in general. So I'm specifically excluding most of the SP500 and the other 30% of TSM which is not SP500. Since you are agreeing share dilution and share buybacks occur reread Simplegift's original post (which again is not really his thesis this is standard CAPM). It is based on not considering these sorts of activities. Which is not unusual, up until recently those sorts of activities were things that in the aggregate and over the long term had no impact on passive minority shareholders.
Your point about market participants with “other motives” (essentially manipulating the float of their stock) in response to the rise of indexing would be much stronger if you are able to provide hard numbers about the magnitude of this influence on the total market as a whole. So far, you’ve just given anecdotal evidence about a few high P/E stocks in the S&P 500.

To disprove William Sharpe’s thesis in the OP (that the holdings of active managers, in aggregate, must be market cap-weighted), one would need to show that the float manipulators are a large and significant enough force to impact the overall valuation of the total market. The numbers presented by Dirghatamas indicate that they are not at this point.

To be fair, you’re also arguing that the influence of these float manipulators might be greater in the future — but again, without hard numbers on the magnitude of this impact on the total market today, it’s hard to assess this claim.
Cordially, Todd

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 5:11 pm

Simplegift wrote:
jbolden1517 wrote:More importantly these are the early signs of how the market is responding to indexing. As index and passive become dominant forces and not just another market participants other market participants have to react to it.
jbolden1517 wrote:My thesis is that there is a problem in SP500 high P/E stocks, not the market in general. So I'm specifically excluding most of the SP500 and the other 30% of TSM which is not SP500. Since you are agreeing share dilution and share buybacks occur reread Simplegift's original post (which again is not really his thesis this is standard CAPM). It is based on not considering these sorts of activities. Which is not unusual, up until recently those sorts of activities were things that in the aggregate and over the long term had no impact on passive minority shareholders.
Your point about market participants with “other motives” (essentially manipulating the float of their stock) in response to the rise of indexing would be much stronger if you are able to provide hard numbers about the magnitude of this influence on the total market as a whole. So far, you’ve just given anecdotal evidence about a few high P/E stocks in the S&P 500.
OK let's just randomly grab the stocks selling shares since my post on this thread (that's fair unless you think I'm psychic). (Most of these aren't SP500 but I want to keep the random element alive):

CYMABAY THERAPEUTICS, INC. CBAY P/E infinite, P/B 10.2
MYND ANALYTICS, INC. MYND P/E infinite, P/B 26.6
XPO LOGISTICS, INC. XPO P/E on normal earnings 82.6, had a great 2017 and stock shot up. P/B 3
OPGEN INC OPGN P/E never made money, P/B 9.2
ARENA PHARMACEUTICALS INC ARNA P/E losing money for years, P/B 8.7
ID SYSTEMS INC IDSY P/E losing money since 2014, P/B 4.7 (highest for its industry)

and since I started typing this 2 more came in for the next 2 days:
RING ENERGY, INC. REI NYSE MKT losing money since 2015 P/B 2.2 (a normal equity sell for a company that likely can't get bonds, this is what you should be seeing)
COMMUNITY HEALTHCARE TRUST INC CHCT P/E of 90, P/B at a mere 1.5 because of regular secondary offerings improving cash. Very high dividend to boost stock price. This idea is kinda cool, use index fund investors to fund your dividend and then give them 70% of the money back that year.

Do I have data, no. The article is only a few weeks ago. But now that BofA has gone public I assume there will be data soon. That being said the activity sure seems consistent with their being a pattern. It is passing the smell test.
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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 5:15 pm

Simplegift wrote: To disprove William Sharpe’s thesis in the OP (that the holdings of active managers, in aggregate, must be market cap-weighted), one would need to show that the float manipulators are a large and significant enough force to impact the overall valuation of the total market. The numbers presented by Dirghatamas indicate that they are not at this point.
I'm not sure why I would need to show this. How much of a bleed IYO is too much? My estimate is about 150 basis points. Say I'm wrong at its only 75? Does that disprove the thesis, especially the potential? Say I'm wrong in the other direction?

Where is the bar on this argument?

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Re: Do Index Funds Distort Market Valuations?

Post by TD2626 » Wed Jul 19, 2017 6:12 pm

A few reactions:

First, I think that one needs to be clear what happens with selling new shares and increasing market cap. Companies only get more capital from indexers by having a legitimately higher market cap. (At least for float-adjusted cap-weighted indices). If a company dumps out new shares, they decrease the stock price due to dilution. With a number of shares that is higher and a lower stock price, the market cap (which equals share price times number of shares) is constant. With market cap constant, the cap-weighted indexers would still be providing the company the same amount of capital. Yes, they may buy some of the new shares to maintain their exposure to the stock - but the amount in the stock would be constant. The company would not have a higher market cap unless it is doing something (like expanding or making large profits) to justify the higher market cap. Yes, indexers can loose money to dilution, but so can active traders.

Second, in regards to comments about the S&P 500 and indexes funds that track it: I think that there can be some slight issues here. Total Stock (or Total World) is better from a theoretical perspective because they invest far more broadly. I have heard studies that suggest a slight bump in share prices for firms that are added to the S&P 500. Active traders and arbitragers, though, ensure that this is only a limited effect.

Think about it this way. If you were a hedge fund manager (retail investors should not attempt this), you could identify pairs of companies that are similar in all regards (sector, profitability, valuation, etc) but one is in the S&P 500 and one isn't. For example, two trucking companies that are otherwise very similar in size, geographical focus, profitability, etc but one is in the S&P and one isn't. You could then invest in the companies that aren't in the S&P. This may create small alpha - for example, the non S&P companies could sometimes end up added to the S&P, getting a small share price bump. However, a flood of money into this strategy would arbitrage away nearly all the alpha (markets are fairly efficient), so you would only get maybe a few basis points in exchange for a lot of work and a lot of risk. The fact that there are probably active hedge funds that do this sort of thing keeps markets efficient and allows retail investors to invest in the S&P 500 index fund and still get decent returns. Yes, the hedge funds and the active funds that do this may make a few basis points, but not much. If there was really a huge profit to be had in this strategy, people would flock to it until 100% or more of the potential profit was arbitraged away, leaving indexers with an efficient fund. Again, retail investors should not try a strategy like this in my opinion. Also, the move towards Total Market index funds seems to make this more of an anachronism.

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 6:38 pm

TD2626 wrote: First, I think that one needs to be clear what happens with selling new shares and increasing market cap. Companies only get more capital from indexers by having a legitimately higher market cap. (At least for float-adjusted cap-weighted indices). If a company dumps out new shares, they decrease the stock price due to dilution.
You are assuming the point in question. That's what used to happen: dilution didn't matter because it just diluted the earnings per share and those investors focused on per share earnings mostly set long term pice. There is a large group of investors who aren't investing based on those sorts of fundamentals at all. These investors aim to hold a constant percentage of the stock. Thus when a stock increases float they respond to this increase by aggressive buying and thus driving up the price. Incidentally they also respond to buy backs by aggressively selling. Any thoughts on who they are?

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Re: Do Index Funds Distort Market Valuations?

Post by David Jay » Wed Jul 19, 2017 6:57 pm

jbolden1517 wrote:
Simplegift wrote: To disprove William Sharpe’s thesis in the OP (that the holdings of active managers, in aggregate, must be market cap-weighted), one would need to show that the float manipulators are a large and significant enough force to impact the overall valuation of the total market. The numbers presented by Dirghatamas indicate that they are not at this point.
I'm not sure why I would need to show this. How much of a bleed IYO is too much? My estimate is about 150 basis points. Say I'm wrong at its only 75? Does that disprove the thesis, especially the potential? Say I'm wrong in the other direction?

Where is the bar on this argument?
The issue isn't so much your thesis as your insistence that index funds have a poor performance when they consistently outperform active funds after fees. You told that new guy over on the TSM thread that it was a "poor" fund. And that it wasn't diversified.

150 basis points and even 75 basis points annually is absurd for the SP500. No other mutual fund, active or passive, can reasonably be expected to outperform the SP500 by 150 basis points over the long haul.

I believe in the small and the value premiums (and tilt my portfolio to demonstrate my faith) but even with all of the academic work (from French/Fama on) it is unlikely that SCV will outperform Large Cap by more than 50-100 basis points. And it is supposed to outperform large cap according to the research. If the SP500 was losing 150 basis points due to float manipulation as you theorize, it should trail SCV by 200 or 250 basis points. But it doesn't.

So while it may be possible for companies to manipulate their float, it is at the margins if at all.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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Re: Do Index Funds Distort Market Valuations?

Post by TD2626 » Wed Jul 19, 2017 6:59 pm

jbolden1517 wrote:
TD2626 wrote: First, I think that one needs to be clear what happens with selling new shares and increasing market cap. Companies only get more capital from indexers by having a legitimately higher market cap. (At least for float-adjusted cap-weighted indices). If a company dumps out new shares, they decrease the stock price due to dilution.
You are assuming the point in question. That's what used to happen: dilution didn't matter because it just diluted the earnings per share and those investors focused on per share earnings mostly set long term pice. There is a large group of investors who aren't investing based on those sorts of fundamentals at all. These investors aim to hold a constant percentage of the stock. Thus when a stock increases float they respond to this increase by aggressive buying and thus driving up the price. Incidentally they also respond to buy backs by aggressively selling. Any thoughts on who they are?
The indexers don't buy aggressively - they would only buy a portion of the new stock floated - and not when it's floated anyway... it would be bought later, when it's added to the index.

For example, say that a company, XYZ corp, had a share price of $100/share and 1,000,000 shares outstanding. It has a market cap of $100,000,000. Assume that in this hypothetical market, we have Index Fund V, which is the only index fund and holds 10% of the economy's money - so it has 10% of XYZ corp's stock. V holds 100,000 shares of XYZ, with a total value of $10,000,000.

XYZ corp decides to issue new shares. It issues 1,000,000 new shares. Do these shares sell for $100 per share? No - the secondary public offering shares are sold at a discount. If the discount isn't substantial enough, they won't be sold. I don't think index funds tend to buy IPO and SPO shares - don't they buy later? Thus, only active funds buy the SPO shares - and the company would have to sell SPO shares for a big discount to get its funding. Say XYZ corp sold the SPO shares for $50 a share. After the SPO, the share price is now $50 a share. There are 2,000,000 shares outstanding, and at $50 a share, the company has the same $100,000,000 market cap. 10% of the market (which is what the indexer V owns) is 200,000 shares - so V needs to buy 100,000 shares. V only buys 10% of the shares sold in the SPO. I wouldn't call that aggressive - most of the shares go to others. Yes, all XYZ corp investors loose to dilution - both index and active. But this is a risk of stock investing - not a risk inherent to indexing.

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Re: Do Index Funds Distort Market Valuations?

Post by TD2626 » Wed Jul 19, 2017 7:03 pm

What about potential for arbitrage? If there was truly a way to get a huge, high risk-adjusted total return above the index, active money would flood in and arbitrage away the potential alpha until it wasn't worth it. This stabilizes markets and allows for reasonable levels of indexing (even 30, 40, 50%) to exist. I think that the risk is that the flood of active money attempting to arbitrage against index changes, for example, would be so large that the active investors have no excess return to divide among themselves - or they even drive down their own returns, and the indexers do better in the short run. In the long run, though, the market stabilizes itself.

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Re: Do Index Funds Distort Market Valuations?

Post by ray333 » Wed Jul 19, 2017 7:04 pm

Indexes ... RoBo investors ...

I feel like there's never gonna be another crash ...

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 7:35 pm

TD2626 wrote: For example, say that a company, XYZ corp, had a share price of $100/share and 1,000,000 shares outstanding. It has a market cap of $100,000,000. Assume that in this hypothetical market, we have Index Fund V, which is the only index fund and holds 10% of the economy's money - so it has 10% of XYZ corp's stock. V holds 100,000 shares of XYZ, with a total value of $10,000,000.

XYZ corp decides to issue new shares. It issues 1,000,000 new shares. Do these shares sell for $100 per share? No - the secondary public offering shares are sold at a discount. If the discount isn't substantial enough, they won't be sold.
Let me tell you how XYZ can sell them at $100 per share. XYZ goes to say Bank A. They offer A the 1m shares on their book at $100/share plus 3 year puts at $100 / share so the collateral is riskless for the bank. In exchange they want a $100m loan which can be repaid via exercise of the put. Interest on the outstanding principle will be covered. However the bank is obligated to sell shares at market price of $120 and use this towards repayment of the principle of the loan.

And there are thousands of variants like this.
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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 8:21 pm

TD2626 wrote:What about potential for arbitrage? If there was truly a way to get a huge, high risk-adjusted total return above the index, active money would flood in and arbitrage away the potential alpha until it wasn't worth it.
That's what's happening. Your problem is you are used to thinking of index mutual funds / etfs as sitting above the market not as part of the market. But of course in reality indexers (and quasi indexers which increase the market share greatly) are just another market participant utilizing a strategy. The control investors in your (quite appropriate language) are seeing the potential for arbitrage. The control investors are arbitraging right now by exploiting this exploitable inefficiency created by indexers to produce cheap financing for their companies. They are using this alpha to pull money from those companies sideways and/or reducing their own holdings at huge profits. They get this high risk-adjusted returns until the index funds bleed off into insignificance again. That's what "arbitraging away" means in this context. The arbitrage process is going to take many years, but it ain't like the opportunity is going anywhere.
TD2626 wrote: This stabilizes markets and allows for reasonable levels of indexing (even 30, 40, 50%) to exist.
We are over those numbers. If you include quasi indexers and funds that cancel each other out to produce an index in the aggregate according to Bank of America and JPMorgan we are at 70%.
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Re: Do Index Funds Distort Market Valuations?

Post by TD2626 » Wed Jul 19, 2017 9:07 pm

What solution, then, is proposed? Buying low cost active funds? If it's a problem, but retail investors can't do anything about it, why does it matter? What should retail investors do? (Not saying I agree that this is a problem - just pointing out that if it is a problem, there seems to be little that a retail investor could do.)

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 9:08 pm

David Jay wrote: The issue isn't so much your thesis as your insistence that index funds have a poor performance when they consistently outperform active funds after fees.
Do they? Then what happened with VPACX? When did I say index funds have poor performance? I said growth stocks have poor performance.
David Jay wrote: You told that new guy over on the TSM thread that it was a "poor" fund. And that it wasn't diversified.
Yes. Because of the way it chooses to invest it often lacks industry diversification. That's become particularly bad for Real Estate and Utilities. It also focus on large and growth. As a component in a portfolio those choices are fine. As a total portfolio those choices are not. Just to take an extreme example: 1998 TSM was about 11% technology. 2 years later 39%. 2 years later back down to 18%. Why should an investor in 2000 have been that exposed to an obviously overvalued group of stocks? Good funds for naive investors don't expose people to the certainty of loss just so they can better track an index. People have to start learning what diversification means again. Statements like "it holds 3600 stocks" without thinking about what percentages it holds in those 3600 need to be challenged.

If we were talking about it as part of a portfolio (the way Schwab handles it) fine. But when being evaluated as an all in one fund, the core stock holding that one bets their entire future on things change. And before you object I understand it is mixed with too little international which is also large growth and thus designed to maximize correlation. That helps the industry diversification and the currency risk is good for the bonds. So certainly I approve of this as better than nothing but again investors can do far better than portfolios structured this badly.

This place has become a cult. The argument about intermediate high quality bonds for diversification is similar. Having stripped most of the diversification benefit away from bonds by not holding duration risk or credit risk means those bonds don't diversify. One can make an argument for those sorts of bonds as a better cash and one can make an argument for good cash. But there is no excuse for people on an investing board not knowing what diversification means and taking pride in their ignorance. I find the habit of teaching blatantly false stuff to people seeking advice and knowledge frankly appalling.
David Jay wrote: 150 basis points and even 75 basis points annually is absurd for the SP500. No other mutual fund, active or passive, can reasonably be expected to outperform the SP500 by 150 basis points over the long haul.
How do you know that? I can think of lots of mutual funds both active and passive that out performed VPACX by 150 basis points.
David Jay wrote: If the SP500 was losing 150 basis points due to float manipulation as you theorize, it should trail SCV by 200 or 250 basis points. But it doesn't.
Your tenses are of you are also confusing the index with the funds. Let me rewrite this. If the SP500 index funds were losing 150 basis points due to float manipulation as you theorize, it would after the process stops be found to have trailed SCV by 200 or 250 basis points. And yes I do think that's likely. The index isn't the one providing the cheap financing the index funds are. As an aside this process might benefit SCG more. It is worth observing to see how the financing gets used as this plays out.

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 9:15 pm

TD2626 wrote:What solution, then, is proposed? Buying low cost active funds? If it's a problem, but retail investors can't do anything about it, why does it matter? What should retail investors do? (Not saying I agree that this is a problem - just pointing out that if it is a problem, there seems to be little that a retail investor could do.)
There is a wealth of asset classes. Just avoiding high P/E SP500 stocks isn't hard. If you want to invest in these companies use funds that diverge wildly from cap weighting. Also since the same process is even worse on bonds avoiding European and most Asian government's debt as well as corresponding country's high quality debt. In general there are tons of asset classes. Not all of them are good buys at any given time.

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Re: Do Index Funds Distort Market Valuations?

Post by David Jay » Wed Jul 19, 2017 9:37 pm

jbolden1517 wrote:
David Jay wrote: 150 basis points and even 75 basis points annually is absurd for the SP500. No other mutual fund, active or passive, can reasonably be expected to outperform the SP500 by 150 basis points over the long haul.
How do you know that? I can think of lots of mutual funds both active and passive that out performed VPACX by 150 basis points.
I don't know why you keep referring to VPACX as an SP500 fund.

Nevertheless, please provide a short list of stock mutual funds that can reasonably be expected to outperform VFIAX by 150 basis points over the next 10 years (to copy the terms Buffett's bet with Seides).
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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Re: Do Index Funds Distort Market Valuations?

Post by Nate79 » Wed Jul 19, 2017 9:43 pm

Is there an EJ salesman in the room?

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Re: Do Index Funds Distort Market Valuations?

Post by patrick013 » Wed Jul 19, 2017 9:55 pm

Simplegift wrote:
jbolden1517 wrote:Since the original article was from BofA let's use them as an example.
Can you provide any links to the original Bank of America and JPMorgan studies that you referenced upthread? Sounds like they'd be interesting and insightful reads. Thanks.
Guide to the Markets
Got me to thinking.....probably not the exact studies you're looking for but one
of the better volumes of market summary information. Odd they think the dollar
index will fall next year.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 9:58 pm

David Jay wrote:I don't know why you keep referring to VPACX as an SP500 fund.
VPACX is an analogy. Japan is a wonderful example of a market where indexing was a disastrous investment strategy. Part of the argument here is that indexing can never be a bad strategy. You are guaranteed to get market return and beat the active managers. Japan proves that isn't the case.
David Jay wrote: Nevertheless, please provide a short list of stock mutual funds that can reasonably be expected to outperform VFIAX by 150 basis points over the next 10 years (to copy the terms Buffett's bet with Seides).
I think of markets as dynamic. This problem could go away. I'm simply claiming it is here now and getting worse. I don't claim to own a crystal ball. But OK, fair bet. I'll pick 3 WisdomTree funds that all track the same index but it do it better.

EPS
DLN
1.3 ::1 leveraged PUTW (compensating for the lower risk).

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Re: Do Index Funds Distort Market Valuations?

Post by David Jay » Wed Jul 19, 2017 10:16 pm

jbolden1517 wrote:
David Jay wrote:I don't know why you keep referring to VPACX as an SP500 fund.
VPACX is an analogy. Japan is a wonderful example of a market where indexing was a disastrous investment strategy. Part of the argument here is that indexing can never be a bad strategy. You are guaranteed to get market return and beat the active managers. Japan proves that isn't the case.
David Jay wrote: Nevertheless, please provide a short list of stock mutual funds that can reasonably be expected to outperform VFIAX by 150 basis points over the next 10 years (to copy the terms Buffett's bet with Seides).
I think of markets as dynamic. This problem could go away. I'm simply claiming it is here now and getting worse. I don't claim to own a crystal ball. But OK, fair bet. I'll pick 3 WisdomTree funds that all track the same index but it do it better.

EPS
DLN
1.3 ::1 leveraged PUTW (compensating for the lower risk).
Nope, no leverage, too hard to verify your actual carrying costs. Do you still want PUTW or will you go with just the other 2 (or pick a different 3rd)?

[edit] EPS? Really? 150BP annual outperformance? It's performance an exact clone of VTIAX (you can rarely distinguish between the two lines on the M* Total Return chart) since inception (just over 10 years). :shock:
Last edited by David Jay on Wed Jul 19, 2017 10:33 pm, edited 1 time in total.
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Re: Do Index Funds Distort Market Valuations?

Post by Dirghatamas » Wed Jul 19, 2017 10:30 pm

jbolden1517 wrote:
This place has become a cult. The argument about intermediate high quality bonds for diversification is similar.
Wow! I spent some time on this thread trying to understand the dissenting view last couple of evenings. It is rational to have an open mind and listen to the opposing argument. Then one needs to look at facts. I looked at facts (share dilution in US stocks and % of trade volume by index funds) and felt there wasn't much here to matter. Upon further reading of jbolden1517 posts, I am starting to take back my open mind. At some point, discussions move away from reasonable/rational debate to tinfoil territory. I am done with this thread. Sorry Simplegift, you had a good, insightful thread going..

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 10:31 pm

David Jay wrote:
jbolden1517 wrote:
David Jay wrote:I don't know why you keep referring to VPACX as an SP500 fund.
VPACX is an analogy. Japan is a wonderful example of a market where indexing was a disastrous investment strategy. Part of the argument here is that indexing can never be a bad strategy. You are guaranteed to get market return and beat the active managers. Japan proves that isn't the case.
David Jay wrote: Nevertheless, please provide a short list of stock mutual funds that can reasonably be expected to outperform VFIAX by 150 basis points over the next 10 years (to copy the terms Buffett's bet with Seides).
I think of markets as dynamic. This problem could go away. I'm simply claiming it is here now and getting worse. I don't claim to own a crystal ball. But OK, fair bet. I'll pick 3 WisdomTree funds that all track the same index but it do it better.

EPS
DLN
1.3 ::1 leveraged PUTW (compensating for the lower risk).
Nope, no leverage, too hard to verify your actual carrying costs. Do you still want PUTW or will you go with just the other 2?
I think the carrying cost of shorting 30% on a 10 year treasury is pretty well known. But regardless, I'll stay with the no leverage rule and FNDX.

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Re: Do Index Funds Distort Market Valuations?

Post by David Jay » Wed Jul 19, 2017 10:45 pm

jbolden1517 wrote:
David Jay wrote:
jbolden1517 wrote:
David Jay wrote:I don't know why you keep referring to VPACX as an SP500 fund.
VPACX is an analogy. Japan is a wonderful example of a market where indexing was a disastrous investment strategy. Part of the argument here is that indexing can never be a bad strategy. You are guaranteed to get market return and beat the active managers. Japan proves that isn't the case.
David Jay wrote: Nevertheless, please provide a short list of stock mutual funds that can reasonably be expected to outperform VFIAX by 150 basis points over the next 10 years (to copy the terms Buffett's bet with Seides).
I think of markets as dynamic. This problem could go away. I'm simply claiming it is here now and getting worse. I don't claim to own a crystal ball. But OK, fair bet. I'll pick 3 WisdomTree funds that all track the same index but it do it better.

EPS
DLN
1.3 ::1 leveraged PUTW (compensating for the lower risk).
Nope, no leverage, too hard to verify your actual carrying costs. Do you still want PUTW or will you go with just the other 2?
I think the carrying cost of shorting 30% on a 10 year treasury is pretty well known. But regardless, I'll stay with the no leverage rule and FNDX.
Got it. EPS, DLN and FNDX

I was sorta' expecting to see some small company value, based on your TSM thread comments...
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Re: Do Index Funds Distort Market Valuations?

Post by aegis965 » Wed Jul 19, 2017 11:08 pm

jbolden1517 wrote:
David Jay wrote:
jbolden1517 wrote:
David Jay wrote:I don't know why you keep referring to VPACX as an SP500 fund.
VPACX is an analogy. Japan is a wonderful example of a market where indexing was a disastrous investment strategy. Part of the argument here is that indexing can never be a bad strategy. You are guaranteed to get market return and beat the active managers. Japan proves that isn't the case.
David Jay wrote: Nevertheless, please provide a short list of stock mutual funds that can reasonably be expected to outperform VFIAX by 150 basis points over the next 10 years (to copy the terms Buffett's bet with Seides).
I think of markets as dynamic. This problem could go away. I'm simply claiming it is here now and getting worse. I don't claim to own a crystal ball. But OK, fair bet. I'll pick 3 WisdomTree funds that all track the same index but it do it better.

EPS
DLN
1.3 ::1 leveraged PUTW (compensating for the lower risk).
Nope, no leverage, too hard to verify your actual carrying costs. Do you still want PUTW or will you go with just the other 2?
I think the carrying cost of shorting 30% on a 10 year treasury is pretty well known. But regardless, I'll stay with the no leverage rule and FNDX.
CSM?
"Value investing is at its core the marriage of a contrarian streak and a calculator." —Seth Klarman

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 11:10 pm

David Jay wrote: Got it. EPS, DLN and FNDX
I was sorta' expecting to see some small company value, based on your TSM thread comments...
This thread is all about cap weighting. That thread was more about different asset classes. For this thread I wanted to pick a portfolio holding a rather mainstream version of the SP500 just using non-cap weightings. It makes the point quite clearly that with very little change you end up with a portfolio that's safer with higher expected returns. All 3 of those options have a value tilt and might drift towards midcap so I expect some value and small premium. But mostly they avoid bad stocks and pick up good ones. I only have to win by 150 basis points. No need to add other factors like different asset classes that could screw me up.

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Re: Do Index Funds Distort Market Valuations?

Post by jbolden1517 » Wed Jul 19, 2017 11:14 pm

aegis965 wrote:CSM?
I like the idea of the fund. The fund holds a lot in futures and futures have weird effects from contango. This is a fund you have to watch carefully because it could start to bleed. The bet I think was meant to be 10 years and forget about it.

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