Does the trend toward index funds mute any bear market?

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Shallowpockets
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Does the trend toward index funds mute any bear market?

Post by Shallowpockets »

As more and more people go the route of Index funds and if keeping those funds through thick and thin, no selling, no market timing, does this mute the effects that might occur should the market drop?
Since the fundamentals of the market are often the same as before a sudden stock market drop, a lot of the selling is fueled by the fear of a dropping market and thus perpetrates the drop.
With the increase in passive index fund money and the BH philosophy of leaving it be due to the long term leveling of the market, are we not now a bit more insured against a drop being as precipitous and deep as in the past?
Lou354
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Re: Does the trend toward index funds mute any bear market?

Post by Lou354 »

It's true that lots of people have been switching from actively-managed funds to index funds. But that doesn't mean they've given up on market timing and become disciplined buy-and-hold investors. I predict many will be unwilling to ride the market down when the next big drop comes. Which it will. They'll remove money from the stock market or switch to actively-managed funds that offer a chance to not lose money.
Avo
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Re: Does the trend toward index funds mute any bear market?

Post by Avo »

Those who buy and hold do not influence the share price after the purchase.

Consider: there are 100 shares (total) of a particular stock. You own 99 and plan to hold. I own one. I bought it for $100, and that was the last price. So your shares are worth $100 each. I now decide to sell, and put out an ask price of $100. No one bids. I drop my price, and drop, and drop, until someone bids (say) $50, and I take that. The price of your 99 shares is now $50 each. It doesn't matter that you held a lot of them and I only had one.

Of course the real world is more complicated than this, but this illustrates the basic idea.
alfaspider
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Re: Does the trend toward index funds mute any bear market?

Post by alfaspider »

Avo wrote:Those who buy and hold do not influence the share price after the purchase.

Consider: there are 100 shares (total) of a particular stock. You own 99 and plan to hold. I own one. I bought it for $100, and that was the last price. So your shares are worth $100 each. I now decide to sell, and put out an ask price of $100. No one bids. I drop my price, and drop, and drop, until someone bids (say) $50, and I take that. The price of your 99 shares is now $50 each. It doesn't matter that you held a lot of them and I only had one.

Of course the real world is more complicated than this, but this illustrates the basic idea.
"Buy and hold" investors don't simply buy everything at a fixed point and time and hold onto it. Most of them continually buy until they retire. This means any stock included in the major indices has a steady stream of buyers who will continue to buy regardless of any external factors. The same investors also don't sell in a downturn, which means they limit supply of shares for sale, propping up price.

That said, I think true BH style investors who actually stick to their guns are a distinct minority- index funds or no. At the next big crash, there will be plenty of panic selling just like there always is.
H-Town
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Re: Does the trend toward index funds mute any bear market?

Post by H-Town »

Shallowpockets wrote:As more and more people go the route of Index funds and if keeping those funds through thick and thin, no selling, no market timing, does this mute the effects that might occur should the market drop?
Since the fundamentals of the market are often the same as before a sudden stock market drop, a lot of the selling is fueled by the fear of a dropping market and thus perpetrates the drop.
With the increase in passive index fund money and the BH philosophy of leaving it be due to the long term leveling of the market, are we not now a bit more insured against a drop being as precipitous and deep as in the past?
Although I don't have data to back this, I think the majority of market is still active tradings.
jbolden1517
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Re: Does the trend toward index funds mute any bear market?

Post by jbolden1517 »

Shallowpockets wrote: As more and more people go the route of Index funds and if keeping those funds through thick and thin, no selling, no market timing, does this mute the effects that might occur should the market drop? Since the fundamentals of the market are often the same as before a sudden stock market drop, a lot of the selling is fueled by the fear of a dropping market and thus perpetrates the drop. With the increase in passive index fund money and the BH philosophy of leaving it be due to the long term leveling of the market, are we not now a bit more insured against a drop being as precipitous and deep as in the past?
I think you are mistaken on both accounts here. Generally the fundamental of the market before a sudden drop suddenly got considerably worse. Investors who are trading the 6-18 mo earnings outlook are not irrationally downgrading the earnings growth prospects they are being quite rational in their assessments and generally are correct in hindsight. Stocks broadly react suddenly as investors realize the problems they are seeing at the individual stock level are broad based and likely in the short term to be self feeding.

Here is what happened in the last 2 really bad selloffs. You tell me if Indexing or Bogle would have made a difference.

As far as fear of a dropping market. That wasn't the case in 2008. In the 2008 the initial drops were caused by people with liquidity problems. The credit markets had frozen up, the stock market was still functioning. They desperately needed money. The sellers believed they were selling their stocks too cheaply, but selling stocks too cheaply was by that point their least bad option. They were panicked about bonds (mostly the sorts of bonds not in mutual funds so retail investors missed the bond market excitement). They were panicked about the bond market, the stock market didn't have them worried at all. That BTW is why the stock market was so volatile. Everyone knew it was undervalued so buyers jumped in, the market would skyrocket. At those higher prices waves of liquidity sellers would move in and grab the available cash they were desperate for. This kept up for 4 months till institutional buyers raised enough cash, TARP was passed, there was a forced loan program...

1987: interest rates were way up and there were extremely attractive investment in the bond market. The stock market looked way overpriced. It made a lot of sense to move more money over to bonds. There was a general belief we might be headed into a bear market as stock investors shifted. Everyone expected a long grinding bear (like the 2000 bear if you went through that) with stocks selling off as money moved to bonds. There hadn't been a real crash since 1929-1932, and no one was leveraged like they had been then on stocks. Moreover, there was an idea called "portfolio insurance" where people were going to dynamically sell futures into a declining market and thus protect themselves. That would work fine in a long grinding bear. The market got increasingly choppy. There might be money to be made if this cleared up, but best to get rebalanced now, diversify into those attractive bonds. There were 2 extremely choppy days as Wednesday and Thursday as people started doing that. The news wasn't great either, more problems with Iran that might mean higher oil prices. Then Friday was nasty, a 4.6% sell off in one day. Everyone knew the market would probably be up on Monday after that completely excessive short term sell off, but still it was best to spend the weekend thinking about the right portfolio to ride out the bear in. Monday the market opens hard down and keeps selling. No one had enough portfolio insurance they had to buy. But when investors in the aggregate short futures, computers buy the futures and short the underlying stocks. No one considered what large volumes of that sort of activity would mean. Humans weren't doing the selling, computers were. Humans were buying stock all through that crash quickly. No one had ever seen anything like that Monday. The panic for retail investors didn't come till Monday night or Tuesday morning between the news and seeing their mutual fund NAVs in the paper. No one told them about the choppy market the week before. Tuesday the pros were in the market buying and it roared back, until the wave of mutual fund selling in late morning because of all the redemptions. Everyone took a breather and the market shot up. That was it. Panic played no major role, it played a minor role the day after the crash. As an aside, ETFs with their lower liquidity can easily start selling below NAV creating the same arbitrage dynamics as futures did then. So even though you missed the prime time viewing, you might be able to catch the rerun.

But to be honest I don't think the rerun happens in the stock market. Right now the stock market is high but not insane. If I had to pick a market likely to crash, it would be the bond market more than the stock market. Stock investors are psychologically prepared for a harsh selloff. Those that stayed in the market after crashes have been rewarded again and again. There are plenty of people sitting on the sidelines ready to throw cash in if there is trouble. Retail bond investors are not ready for something like that. They have been told bonds are safe. They are mostly ETF and mutual funds and haven't actually ever purchased a bond directly, except maybe munis from their broker. No one has bothered explaining to them how illiquid the underlying bond market really is when it is under stress. And wow those ETFs are easy to sell.
jbolden1517
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Re: Does the trend toward index funds mute any bear market?

Post by jbolden1517 »

thangngo wrote:Although I don't have data to back this, I think the majority of market is still active tradings.
Depends what you mean by "active traders". If you mean stock pickers, no. If you mean arbitrage investors yes. According to JPMorgan the volume they are seeing on the SP500 is: 3/7 passive investors, 1/7 fundamental investors, 3/7 arbitrage investors. On the other parts of the stock market, much less passive investing.
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Nate79
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Re: Does the trend toward index funds mute any bear market?

Post by Nate79 »

High speed trading and active trading make up a vast majority of trades which set the market price of securities. Buy and hold investors (and indexers) are by far the minority when it comes to affecting the market price in a trade.
daveydoo
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Re: Does the trend toward index funds mute any bear market?

Post by daveydoo »

Shallowpockets wrote: With the increase in passive index fund money and the BH philosophy of leaving it be due to the long term leveling of the market, are we not now a bit more insured against a drop being as precipitous and deep as in the past?
Although these two are inseparable on this forum, they are separable in the real world -- tax-deferred accounts increasingly offer indexed funds. But the people who invest in them are still not super-sharp. Hence the enormous diversion between asset-class returns over the past two decades and individual investor returns over that same interval. You can still buy-and-sell in your 401(k), even if it's packed with high-quality investment options.

Also, I share some of the fear about the index-fund investing "tail" wagging the equity "dog" -- but all the nay-saying I read seems to be coming from hedge funds and other active managers. They even cite eventual mispricing of assets, etc. I would think they'd be in the best position to quietly capitalize on those artifacts of index-fund penetration, if the threat were genuine...so why all the complaining? :D
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jbolden1517
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Re: Does the trend toward index funds mute any bear market?

Post by jbolden1517 »

daveydoo wrote: Also, I share some of the fear about the index-fund investing "tail" wagging the equity "dog" -- but all the nay-saying I read seems to be coming from hedge funds and other active managers. They even cite eventual mispricing of assets, etc. I would think they'd be in the best position to quietly capitalize on those artifacts of index-fund penetration, if the threat were genuine...so why all the complaining? :D
Because they aren't in the best position to capitalize. In general you are talking about the people who used to trade earnings 6-18 months out. Indexing is a counter researching strategy. Indexing assumes that prices are fairly well set by investors doing research. By buying at market prices blindly in the way that's cheapest to manage (cap weighting) the index fund arbitrages the cost of the research without incurring it. As indexing becomes increasingly popular however stocks have stopped responding to changes in earnings. If realized earnings no longer have much impact on stock price doing research to estimate earnings 6-18 mo no longer has any market return. Now of course over the long haul earnings yield (earnings + earnings growth) will determine the minimum eventual return and market mis-pricing simply creates opportunities to increases that eventual return. But over the short term. It doesn't do much of anything. Meanwhile the research cost immediately damage the return of 6-18 mo earnings traders. Index is a counter strategy that works against active passive minority shareholders, there is not much they can do.
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Now the people who are in the best position to capitalize are the control investors. Index fund investors are float traders, control investors can manipulate float. They can force the index fund to buy when the stock is overpriced and provide their company with cheap equity financing and then turnaround and force the index fund to sell when the company is underpriced getting control investors a greater percentage of the eventual upward surge. They don't need to any do research they already know the company is worth, at least more than any outsider. Control investors aren't looking to make a quick profit in 18mo or less and sell out their stock position. Rather they have often dedicated their lives to these companies, they are just as patient if not more so than the index funds.

The message you are hearing from earnings oriented fundamental investors is capitulation. Congratulations! You won round 1. Round 2 you go up against different opponents with different strategies.
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tadamsmar
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Re: Does the trend toward index funds mute any bear market?

Post by tadamsmar »

jbolden1517 wrote:
thangngo wrote:Although I don't have data to back this, I think the majority of market is still active tradings.
Depends what you mean by "active traders". If you mean stock pickers, no. If you mean arbitrage investors yes. According to JPMorgan the volume they are seeing on the SP500 is: 3/7 passive investors, 1/7 fundamental investors, 3/7 arbitrage investors. On the other parts of the stock market, much less passive investing.
Arbitrage involve trading on a sure thing, for sure profit. Could someone explain how 3/7 of volume could be arbitrage? Seems implausible.
IlliniDave
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Re: Does the trend toward index funds mute any bear market?

Post by IlliniDave »

Maybe a trend underlying the trend (the possibility of a growing contingent of buy/hold proponents) could have a small affect on volatility if enough of them are able to stick to it. It could mean a few less sellers out there. But I think that would be a long way from muting a bear market.
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jbolden1517
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Re: Does the trend toward index funds mute any bear market?

Post by jbolden1517 »

tadamsmar wrote:
jbolden1517 wrote:
thangngo wrote:Although I don't have data to back this, I think the majority of market is still active tradings.
Depends what you mean by "active traders". If you mean stock pickers, no. If you mean arbitrage investors yes. According to JPMorgan the volume they are seeing on the SP500 is: 3/7 passive investors, 1/7 fundamental investors, 3/7 arbitrage investors. On the other parts of the stock market, much less passive investing.
Arbitrage involve trading on a sure thing, for sure profit. Could someone explain how 3/7 of volume could be arbitrage? Seems implausible.
In practice its not a "sure thing" but rather exploiting distinctions. What you see a lot of is trading the value of the 500 stocks underlying SP500 futures vs. the future itself. Trading the futures relative to the options contracts which induces the stock trades. Trading 0 risk vs. positions vs. short term bills like stock + put + short call. Trading theta on fixed buyers (like passive funds).

I'll give you a good example of one of the ways the market has adopted to widespread indexing. Let me give you another one then. During the 1990s Vanguard and DFA often outperformed their index. They way they did this was by using a patient buyer, patient seller strategy. Essentially they aim to play the spread and make market accumulating shares but also feeding traders. When the majority of traders were trading trends or fundamentals this worked really well and so DFA and Vanguard (DFA moreso than Vanguard) outperformed the index by making market.

Today's traders have adopted to patient buyer, patient seller. Assume a stock is trading at $100. Indexers have buys at $98 and sells at $102. From the perspective of a trader they have an infinitely large put at $98 / share. Which means they can profitably and safely short the call (usually with a weekly) at $98 and long the stock. If they actually bought the put at $98 this would be market neutral and the value of the trade would be $0. But remember they are getting that put for free. So while they collect the theta from the short call they don't have to pay the corresponding theta for the long put position. Their initial buy in the aggregate pushes the share price up. It means the index fund is less likely to get the execution price they were hoping for, some of the shares they bought are now going to the call buyer. The call buyer is often getting a bit of a deal since they are needed for the trader to realize the profit on the free put.

Again this option buyer doesn't care about the discounted value of the future dividends and isn't rationally setting prices. This buyer is essentially getting the interest on a bond (the theta decay) that the index fund is paying for. Now of course the call buyer is usually a passive minority shareholder. But since he bought the stock he gets to look ahead at the week's news.

Now with this position think about what happens with the 1-6 days news.
The news is negative (i.e it would have pushed the stock to $98 or below) -- index fund gets their execution at the price they would have gotten prior to the news. The news is not priced in when they buy. The call buyer doesn't buy he gets the benefits the of the theta he paid for getting to look ahead.

The news is neutral or positive -- the index fund doesn't execute. The call buyer will. He got the safety of looking ahead.

In a day or so the index fund has to raise their band to say $99/$103 and the whole game starts over. The same thing happens at the top of the range if the Indexes are making market except this time the trader is getting a free call and will make money by selling the put at $102 and shorting as the stock goes higher preventing the index from making their sale.

This execution drag isn't huge. It only effects inflows outflows and it only effects the price a little bit. But it probably is about 20 basis points of bleed on executions as index funds grow. And that's the reason that Vanguard and co. at least aren't beating their index so regularly anymore. Their actions have become too predictable to other market participants. When they were small players you couldn't do this because the index fund's buy sells are obscured by all the noise from the other players. That's changed.
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arcticpineapplecorp.
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Re: Does the trend toward index funds mute any bear market?

Post by arcticpineapplecorp. »

High quality short to intermediate bonds or other fixed income (CDs, cash, etc.) will mute the effects of the bear market. Don't count on the stock market to do that for you. Indexing the market just means you've eliminated several risks (stock, sector, size, style and country) but not all. You can't eliminate market risk. But you can reduce the effects of this market risk, and that's by holding bonds like the total bond market index fund. You dig?

Say the stock market goes down 20% and bonds hold steady (no gains/no losses). Then the following portfolios (of stocks/bonds) would perform:

Stock/Bond Return
100% / 0%... -20%
90% / 10%... -18%
80% / 20%... -16%
70% / 30%... -14%
60% / 40%... -12%
50% / 50%... -10%
40% / 60%... -8%
30% / 70%... -6%
20% / 80%... -4%
10% / 90%... -2%
0% / 100%... 0%

How much risk do you want to take? Choose enough bonds to mute the bear to the extent you want it muted, while realizing that bonds also mute the bull market. LIfe's full of tradeoffs.
It's "Stay" the course, not Stray the Course. Buy and Hold works. You should really try it sometime. Get a plan: www.bogleheads.org/wiki/Investment_policy_statement
Bastiat
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Re: Does the trend toward index funds mute any bear market?

Post by Bastiat »

Avo wrote:Those who buy and hold do not influence the share price after the purchase.

Consider: there are 100 shares (total) of a particular stock. You own 99 and plan to hold. I own one. I bought it for $100, and that was the last price. So your shares are worth $100 each. I now decide to sell, and put out an ask price of $100. No one bids. I drop my price, and drop, and drop, until someone bids (say) $50, and I take that. The price of your 99 shares is now $50 each. It doesn't matter that you held a lot of them and I only had one.

Of course the real world is more complicated than this, but this illustrates the basic idea.
This is an incredibly simplistic (and incorrect) interpretation of market forces. It sounds like you're taking the concept of price setting at the margin and conflating it with the economic fundamental of scarcity.

In effect, buy and hold investors remove supply from the market (increase scarcity). As quantity sold decreases, for a constant demand price goes up.

You're saying that all of the gold sitting in central bank vaults has no effect on price, despite the fact that all that gold absent from the market makes it more scarce and thus drives up price. If that gold were on the open market the price of gold would obviously go down.
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Re: Does the trend toward index funds mute any bear market?

Post by pkcrafter »

Does the trend toward index funds mute any bear market?
In a word, No

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Re: Does the trend toward index funds mute any bear market?

Post by magneto »

Shallowpockets wrote: 1. As more and more people go the route of Index funds
2. and if keeping those funds through thick and thin, no selling, no market timing,

does this mute the effects that might occur should the market drop?

With the increase in passive index fund money and the BH philosophy of leaving it be due to the long term leveling of the market, are we not now a bit more insured against a drop being as precipitous and deep as in the past?
Two separate issues :!:

2. Is conditional on human nature not having changed.
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Top99%
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Re: Does the trend toward index funds mute any bear market?

Post by Top99% »

I guess I am not convinced people who hold index funds are any less likely to panic, sell and contribute to a positive feedback cycle putting more downward pressure on prices than people who hold active funds. Not all people who buy index funds have a Boglehead mindset. But, we won't really know until the next bear market hits.
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