Effect of Index funds on Market Efficiency

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finance_learner
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Effect of Index funds on Market Efficiency

Post by finance_learner » Wed Jun 20, 2018 7:04 pm

Hi,

I'm just your everyday investor but I've read the large flow of capital into index funds (now comprising somewhere near half of stock investments). I wonder how that affects Market Efficiency as it pertains to individual investors in the long term (if we expect the proportion of funds in index funds to continue to grow)?

Specifically, should we be worried that there are insufficient investors doing the necessary research and thinking to keep markets efficient. After all, I recall that one of the assumptions of index fund investments is efficient market hypothesis, all information is priced into the market... But if no investor thinks, will there be inefficiencies or will inefficiencies be exploited more effectively by those who do?

What do you all think?

rkhusky
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Re: Effect of Index funds on Market Efficiency

Post by rkhusky » Wed Jun 20, 2018 7:21 pm

Since people like to make money, there will always be enough traders to keep the market efficient.

columbia
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Re: Effect of Index funds on Market Efficiency

Post by columbia » Wed Jun 20, 2018 7:33 pm

Since there will always be certain people who believe that they smarter than the market, there will always be enough traders to keep the market efficient.

At any given time, some will be smarter, but at the expense of those who are failing to be at that particular moment. Holding the market is the neutral and least risky position to take.

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fortyofforty
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Re: Effect of Index funds on Market Efficiency

Post by fortyofforty » Wed Jun 20, 2018 7:35 pm

If everyone indexed, the prices would essentially be "set" on the very last trade. Then, prices of all stocks would move up in proportion to the overall inflow of new cash, minus the outflow of cash as people needed the money. However, there will always be people who try to outguess the market, or get in front of an expected move. It's human nature. As an index investor, I'm not sure I would notice a difference in market movements or the performance of my individual investments.

Also, don't forget, speaking about indexing, there are thousands of "index" funds and ETFs covering the whole market and hundreds of slices of the market. Sometimes those slices are highly specialized. Trades in and out of these subset indexes would also help serve to keep things "efficient", I think.
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SimpleGift
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Re: Effect of Index funds on Market Efficiency

Post by SimpleGift » Wed Jun 20, 2018 7:52 pm

finance_learner wrote:
Wed Jun 20, 2018 7:04 pm
I'm just your everyday investor but I've read the large flow of capital into index funds (now comprising somewhere near half of stock investments).
Index funds and ETFs make up about half of the managed funds industry — but the managed funds industry only accounts for about one-third of the entire U.S. equity market capitalization today (chart below).
Other market participants — including institutions, hedge funds and retail stock investors — hold the remaining two-thirds of market cap (some indexed). Thus there is more than enough active trading for efficient price discovery and markets.
Cordially, Todd

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peterinjapan
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Re: Effect of Index funds on Market Efficiency

Post by peterinjapan » Wed Jun 20, 2018 9:51 pm

To balance out Bogleheads, I sometimes hang out on Reddit, where everyone is holding individual stocks and the /r/ETFs subreddit has nobody in it. I commented on this once, and someone said, "Expansion of passive investing reduces the pool of money seeking to outperform, thereby making outperformance easier. Please add to your ETF holdings."

Any thoughts on this?

dumbmoney
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Re: Effect of Index funds on Market Efficiency

Post by dumbmoney » Thu Jun 21, 2018 1:49 am

It could go either way, it depends whether indexing is growing more at the expense of unskilled traders (who are a source of inefficiency) or more at the expense of skilled pros.
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Re: Effect of Index funds on Market Efficiency

Post by Call_Me_Op » Thu Jun 21, 2018 5:54 am

Nothing to worry about.
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nisiprius
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Re: Effect of Index funds on Market Efficiency

Post by nisiprius » Thu Jun 21, 2018 5:56 am

At Walmart, do you try to negotiate a deal by haggling with the checkout clerk, or do you just pay the marked price? In real life, with your real purchases, what percentage of your dollars do you spend on purchases where you have done serious comparison shopping?

Except in two traditional markets--buying cars and buying houses--most people do not haggle over prices or buy at auction. They are price takers who just pay the marked price... because they do not have the deep level of knowledge needed to be successful negotiating against professionals.

In most consumer markets, "price discovery" is being performed by a tiny and very well informed percentage of the market. Does this damage our capitalist system?
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.

ignition
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Re: Effect of Index funds on Market Efficiency

Post by ignition » Thu Jun 21, 2018 6:55 am

peterinjapan wrote:
Wed Jun 20, 2018 9:51 pm
To balance out Bogleheads, I sometimes hang out on Reddit, where everyone is holding individual stocks and the /r/ETFs subreddit has nobody in it. I commented on this once, and someone said, "Expansion of passive investing reduces the pool of money seeking to outperform, thereby making outperformance easier. Please add to your ETF holdings."

Any thoughts on this?
By definition the market capitalization weighted indexer should earn the average return no? With about 50% of active investors outperforming and 50% underperforming? And indeed, as someone else said, if only the skilled pro's remain, it won't be easier to outperform. The opposite actually...

Tamalak
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Re: Effect of Index funds on Market Efficiency

Post by Tamalak » Thu Jun 21, 2018 10:02 am

finance_learner wrote:
Wed Jun 20, 2018 7:04 pm
Specifically, should we be worried that there are insufficient investors doing the necessary research and thinking to keep markets efficient. After all, I recall that one of the assumptions of index fund investments is efficient market hypothesis, all information is priced into the market... But if no investor thinks, will there be inefficiencies or will inefficiencies be exploited more effectively by those who do?
First, there is absolutely no way there will ever not be enough "fishermen" trying to find and correct market mispricing. The rewards for doing so are phenomenal and will get even MORE phenomenal if there is less competition.

Second, even if somehow there aren't enough price setters and the prices of stocks start to slide around a little bit from where they should be, who cares? Things are just as likely to be underpriced as overpriced. The strategy of buying and holding an index would still work just as well. There might be a tiny bit more volatility and a tiny bit more of a bid/ask spread. Yawn.

david1082b
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Re: Effect of Index funds on Market Efficiency

Post by david1082b » Thu Jun 21, 2018 10:18 am

peterinjapan wrote:
Wed Jun 20, 2018 9:51 pm
To balance out Bogleheads, I sometimes hang out on Reddit, where everyone is holding individual stocks and the /r/ETFs subreddit has nobody in it. I commented on this once, and someone said, "Expansion of passive investing reduces the pool of money seeking to outperform, thereby making outperformance easier. Please add to your ETF holdings."

Any thoughts on this?
/r/investing is more of the main place on Reddit, 500k members, lots of index proponents. /r/etfs is more of a niche subreddit. I had never heard of it but have known about /r/investing for several years. Certain subs become the dominant ones due to having been around longer or getting some media attention or having a name that is more universal. Target Retirement funds are not ETFs generally.

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JoMoney
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Re: Effect of Index funds on Market Efficiency

Post by JoMoney » Thu Jun 21, 2018 10:31 am

finance_learner wrote:
Wed Jun 20, 2018 7:04 pm
...After all, I recall that one of the assumptions of index fund investments is efficient market hypothesis, all information is priced into the market...
No.
http://marriottschool.net/emp/SRT/passive.html
...If prices in the stock market are not efficient, and investing is a skill-based game, then disadvantaged or low skilled investors who try to actively manage their portfolios will consistently lose to players with an advantage. If we reverse the premise of this paper and assume that the stock market is perfectly efficient, then advantages don't matter -- it's all luck -- and less-skilled players have the same one in three chance of beating the market as anyone else. In other words, market efficiency protects the less-skilled investor from consistently making bad investments because all stocks are fairly priced. There is, on the other hand, no such protection in a market where stocks are routinely mispriced. The active investing majority that underperforms the index will tend to be the same year after year. Thus, the argument for indexing is even stronger for individual investors if the stock market is not efficient. The game of poker provides, in some respects, an instructive analogy. Poker is a zero sum game, similar to active investing compared to indexing, and poker combines luck and skill, consistent with the assumption of a less than perfectly efficient market. An old adage among professional poker players applies to those deciding to participate in the active investing game. "If you don't know who the mark is, get up and leave the table, because it's you."
https://www.vanguard.com/bogle_site/sp2 ... Mrkts.html
...But the EMH may well prove less important in investment theory than a new wisdom that is beginning to emerge. I call it the CMH: The Cost Matters Hypothesis. Like the EMH before it, the CMH posits a conclusion that is both trivially obvious and remarkably sweeping: The mathematical expectation of the speculator is a loss equal to the amount of transaction costs incurred. When he concluded otherwise, that “the mathematical expectation of the speculator is zero,” Bachelier was wrong.

So, too, the mathematical expectation of the long-term investor is a shortfall to the stock market’s return, a shortfall that is precisely equal to the costs of our system of financial intermediation—the sum total of all those advisory fees, marketing expenditures, sales loads, brokerage commissions, transaction costs, custody and legal fees, and securities processing expenses. Intermediation costs in the U.S. equity market may well total as much as $300 billion a year, nearly 3% of the value of that $12 trillion market.

We don’t need the EMH to explain the dire odds that investors face in their quest to beat the stock market. We need only the CMH. Whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur.
https://www.marketwatch.com/story/how-t ... 2014-03-28
...the winner of a professional golf tournament must execute difficult shots and outperform the competition. Professional golf is a Winner's Game — the winner defeats his opponent by superior play. The winner of an amateur golf tournament is often the player who makes the fewest mistakes, shuns risky shots and avoids penalty strokes. Amateur golf is a Loser's Game — the loser usually defeats himself by poor play. ...
Most of the investment advice amateur investors receive is based on the faulty premise that professional investors are playing a Winner's Game. It seems logical that bright, articulate and skillful investment managers can, just like talented golf and tennis professionals, outperform the competition and produce market beating performance. This belief persists despite the recurring evidence that it is false (see the latest SPIVA Scorecard). In Ellis' words, most "investment managers aren't beating the market — the market is beating them."
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lack_ey
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Re: Effect of Index funds on Market Efficiency

Post by lack_ey » Thu Jun 21, 2018 10:42 am

Indexing is currently less than 5% of trading volume. Most of the rest is institutional, not driven by retail investors. There are many more hedge funds, mutual funds, etc. than before, on top of HFT and all kinds of algorithmic trading. Bid/ask spreads are down, volume is higher than historical. There's more price discovery now, not less.

Indexing can get you the index's return minus some costs and frictions (and plus some potentially based on securities lending and implementation), regardless of market efficiency.

BrklynMike
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Re: Effect of Index funds on Market Efficiency

Post by BrklynMike » Thu Jun 21, 2018 10:44 am

It seems to me that there are a number of possible consequences of indexing. This article seems the most likely to me.

http://www.philosophicaleconomics.com/2 ... iveactive/
"In a world of uncertainty, one should focus more on the consequences than the probabilities." - Benjamin Graham

finance_learner
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Re: Effect of Index funds on Market Efficiency

Post by finance_learner » Thu Jun 21, 2018 4:04 pm

Thank you all for the great insights. You all seem to make very compelling arguments as to why I shouldn't worry.

My only question is attribution of institutions as "non-index"-I just don't know enough, I would assume that a sizable chunk of institutions offer index and target date funds?
SimpleGift wrote:
Wed Jun 20, 2018 7:52 pm
finance_learner wrote:
Wed Jun 20, 2018 7:04 pm
I'm just your everyday investor but I've read the large flow of capital into index funds (now comprising somewhere near half of stock investments).
Index funds and ETFs make up about half of the managed funds industry — but the managed funds industry only accounts for about one-third of the entire U.S. equity market capitalization today (chart below).
Other market participants — including institutions, hedge funds and retail stock investors — hold the remaining two-thirds of market cap (some indexed). Thus there is more than enough active trading for efficient price discovery and markets.

magicrat
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Re: Effect of Index funds on Market Efficiency

Post by magicrat » Thu Jun 21, 2018 4:35 pm

Even if your premise was true, how would that change your strategy?

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SimpleGift
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Re: Effect of Index funds on Market Efficiency

Post by SimpleGift » Thu Jun 21, 2018 4:41 pm

finance_learner wrote:
Thu Jun 21, 2018 4:04 pm
My only question is attribution of institutions as "non-index"-I just don't know enough, I would assume that a sizable chunk of institutions offer index and target date funds?
This 2017 Reuters article slices the global equity pie a bit differently from my post and may be what you're looking for:
Reuters wrote:The estimate on Tuesday showed that $11.9 trillion in stocks were owned by mutual funds, exchange-traded funds, institutional accounts and private investors that track an index. That accounts for 17.5 percent of the $67.9 trillion in global equity market capitalization, according to the data.

Stocks in actively managed hedge funds, mutual funds and institutional accounts total $17.4 trillion, 25.6 percent of the global equity market cap, according to the report.

The remaining 57 percent are assets held by governments, pension funds, insurers or corporations. Such holdings are not overseen by an asset manager and do not track an index.
So about 18% of global equity by market cap is indexed or passively-managed, including institutional and private investors.
Cordially, Todd

GrowthSeeker
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Re: Effect of Index funds on Market Efficiency

Post by GrowthSeeker » Fri Jun 22, 2018 10:20 am

Consider the universe of stocks that just barely don't qualify to be part of some index.
Such stocks will "unfairly" have a lower demand for purchase of their shares. They will have a tendency to continue to not qualify for that index, even more so. So there is an artificial barrier they must overcome if they are to gain enough of whatever they are lacking in order to be part of that index. The stronger ones will make it, the weaker ones will not.

The effect, I think, is to delay turnover of market leaders. An increased inertia in maintaining the status quo. But eventually the truth will come out, mostly.

For example, if 10% more money had been flowing into DIA, it might have taken weeks or months longer for GE to be booted off the DJIA.
Just because you're paranoid doesn't mean they're NOT out to get you.

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David Jay
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Re: Effect of Index funds on Market Efficiency

Post by David Jay » Fri Jun 22, 2018 11:04 am

lack_ey wrote:
Thu Jun 21, 2018 10:42 am
Indexing is currently less than 5% of trading volume. Most of the rest is institutional, not driven by retail investors. There are many more hedge funds, mutual funds, etc. than before, on top of HFT and all kinds of algorithmic trading. Bid/ask spreads are down, volume is higher than historical. There's more price discovery now, not less.
This is important and overlooked in a lot of these arguments. Price discovery is from trading, not from ownership.

If a group, say a family trust, held 90% of, say, Exxon, that would not significantly affect price discovery. The remaining 10% of shares that are actively traded would set the price.
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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