Is there a point of "Peak Passive" with index funds?

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Noob0707
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Is there a point of "Peak Passive" with index funds?

Post by Noob0707 »

Passively managed investments seem to be gaining in popularity over the past several years, and index funds now account for a substantial share of investors equity holdings. Is there a point when index funds are such big share of the market that their returns fall?

There are 2 risks that come to mind:

1. Passively managed funds are advertised as a "set-it-and-forget-it" way of investing. Is there a point when so many investors could take that hands-off approach that active investors take advantage of these index funds, thus hurting their returns?

2. A passively managed fund that adheres to a specific index (such as VFINX tracking the S&P 500) has to hold stock in the 500 largest companies in the US equities market. Therefore everyone knows its purchase decisions. What if outside investors buy up a company's stock immediately after it moves from #501 to #500 according to size, knowing that the index fund is then going to have to purchase that stock?

What is the limiting factor for the growth of passively managed index funds? Will they soon constitute the majority of everyone's retirement plans? Why or why not? TIA!
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JoMoney
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Re: Is there a point of "Peak Passive" with index funds?

Post by JoMoney »

Noob0707 wrote: Sun Jun 24, 2018 1:30 pm... a specific index (such as VFINX tracking the S&P 500) has to hold stock in the 500 largest companies in the US equities market. Therefore everyone knows its purchase decisions...

That's not how the S&P 500 is constructed.
Every mutual fund publishes it's holdings quarterly, so to the extent that there are inflows and outflows to the fund, everyone knows what it's going to be purchasing.
The advantage of a broad-market index fund is it does very very little trading, so there are fewer opportunities to be taken advantage of compared to a fund or strategy that has higher turnover. With an index, the additions and removals are usually at the fringes making up a very small part of the portfolio.

The issue with the broad market getting overpriced or falling is distinctly different then whether or not buying the broad market is a good way to invest in stocks. If/when the broad market falls, stock investors will lose regardless.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
heyyou
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Re: Is there a point of "Peak Passive" with index funds?

Post by heyyou »

There will always be risks, some are known and some will be surprises. Passive investing has enough risks that it is only better than everything else that has been tried so far.
Northern Flicker
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Re: Is there a point of "Peak Passive" with index funds?

Post by Northern Flicker »

2. A passively managed fund that adheres to a specific index (such as VFINX tracking the S&P 500) has to hold stock in the 500 largest companies in the US equities market. Therefore everyone knows its purchase decisions. What if outside investors buy up a company's stock immediately after it moves from #501 to #500 according to size, knowing that the index fund is then going to have to purchase that stock?
Front-running index changes for some indices can be a problem. It seems to be well established that the Russell small-cap indices have been front-runned successfully in the past. Russell has made changes to their index construction and governance methods to address the issue, but I don’t know whether it is generally accepted that the issue has been fully addressed.

I’m confident that people have tried and continue to try to front-run S&P500 changes. It used to be S&P would announce changes to the index on arbitrary Wednesdays at market close, and index fund managers would have an evening scramble to get their trades queued up first or as early as possible with brokers so they would execute first thing the next morning.

With the growth of indexing, that became impractical and now S&P announces index changes at market close on Mondays, with inclusion in the index some days later (an average of 5 days later I think). There is then a free-for-all period of index fund managers and any front-runners to do transactions. The idea is that this is time for the values to stabilize before index inclusion. The index return may leave some return on the table, but the index fund managers have the same opportunity to turn that into positive tracking error as the front-runners have to front-run it.

S&P maintains a pool of 10 companies at any point in time as candidates for inclusion if a company needs to be booted out. The selection from the 10 is made in a fairly unpredictable way. I think the bigger concern is people shorting S&P500 stocks not doing well in the hope they will get booted out of the index.

If you want to avoid that altogether, you can just hold a total market index. If you specifically want to exclude small-caps say because you want to include small-caps with a value-tilted portfolio, you can just hold a less popular index like the CRSP Large-cap index which has a little over 600 stocks or the Russell 1000, both of which hold both sides of the S&P500 boundary. Of course being less popular means paying a higher ER for a fund tracking the index.

If the Russell 1000 became popular for some reason, front-running could become a problem, given Russell’s history of index governance, but that does not seem likely. Front-running of the Russell 2000 currently may even improve returns of the Russell 1000, but not by much if so. Stocks added to the R1000 contribute to a very small percentage of market cap of the R1000.
Last edited by Northern Flicker on Sun Jun 24, 2018 4:34 pm, edited 1 time in total.
Topic Author
Noob0707
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Re: Is there a point of "Peak Passive" with index funds?

Post by Noob0707 »

Thank you jalbert and everyone else who took the time to teach me. I didn't know that "front running" was the term, but that's the phenomenon that I was getting at.

It seems like total market indices are a good way to avoid it. Thanks!
Ron Scott
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Re: Is there a point of "Peak Passive" with index funds?

Post by Ron Scott »

I think the markets have gotten more efficient over time and front running has become less of an issue; correct me if I’m wrong here.

But regardless of any gaming, passive index funds do better. Not sure there’s more to it than that.
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.
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Phineas J. Whoopee
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Re: Is there a point of "Peak Passive" with index funds?

Post by Phineas J. Whoopee »

Welcome Noob0707. Variations of your question get asked a lot. Here's a link to a search of past threads:

What if everybody indexed?

PJW
longinvest
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Re: Is there a point of "Peak Passive" with index funds?

Post by longinvest »

Dear Noob0707,
Noob0707 wrote: Sun Jun 24, 2018 1:30 pm 2. A passively managed fund that adheres to a specific index (such as VFINX tracking the S&P 500) has to hold stock in the 500 largest companies in the US equities market. Therefore everyone knows its purchase decisions. What if outside investors buy up a company's stock immediately after it moves from #501 to #500 according to size, knowing that the index fund is then going to have to purchase that stock?
I suggest that you consider investing into the Three-Fund Portfolio composed of total-market cap-weighted index funds which aren't vulnerable to front-running:
  • Vanguard Total Stock Market Index Fund (VTSMX) which holds 3,628 stocks
  • Vanguard Total International Stock Index Fund (VGTSX) which holds 6,330 stocks
  • Vanguard Total Bond Market Index Fund (VBMFX) which holds 8,465 bonds
That's a total of 18,423 distinct securities with just three funds.

See the Three-Fund Portfolio post for additional information.
Variable Percentage Withdrawal (bogleheads.org/wiki/VPW) | One-Fund Portfolio (bogleheads.org/forum/viewtopic.php?t=287967)
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jeffyscott
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Re: Is there a point of "Peak Passive" with index funds?

Post by jeffyscott »

jalbert wrote: Sun Jun 24, 2018 3:00 pmIf you specifically want to exclude small-caps say because you want to include small-caps with a value-tilted portfolio, you can just hold a less popular index like the CRSP Large-cap index which has a little over 600 stocks or the Russell 1000, both of which hold both sides of the S&P500 boundary. Of course being less popular means paying a higher ER for a fund tracking the index.
The ER difference between Vanguard 500 Index Admiral (VFIAX) and the Vanguard Large Cap Index Admiral (VLCAX) is only 0.01%.

Or alternatively, the ER of the Vanguard Large Cap Index Admiral (VLCAX) is 25% higher than Vanguard 500 Index Admiral (VFIAX) :shock: :wink:

There's also the Schwab 1000 (aka. Russell 1000) at the same ER as VLCAX.
Northern Flicker
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Re: Is there a point of "Peak Passive" with index funds?

Post by Northern Flicker »

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JoMoney
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Re: Is there a point of "Peak Passive" with index funds?

Post by JoMoney »

jeffyscott wrote: Sun Jun 24, 2018 4:56 pm
jalbert wrote: Sun Jun 24, 2018 3:00 pmIf you specifically want to exclude small-caps say because you want to include small-caps with a value-tilted portfolio, you can just hold a less popular index like the CRSP Large-cap index which has a little over 600 stocks or the Russell 1000, both of which hold both sides of the S&P500 boundary. Of course being less popular means paying a higher ER for a fund tracking the index.
The ER difference between Vanguard 500 Index Admiral (VFIAX) and the Vanguard Large Cap Index Admiral (VLCAX) is only 0.01%.

Or alternatively, the ER of the Vanguard Large Cap Index Admiral (VLCAX) is 25% higher than Vanguard 500 Index Admiral (VFIAX) :shock: :wink:

There's also the Schwab 1000 (aka. Russell 1000) at the same ER as VLCAX.
... Or alternatively, you can look at the difference in performance between the S&P 500 and these other indices/funds and question whether this is a meaningful issue at all, or just more noise.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
Northern Flicker
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Re: Is there a point of "Peak Passive" with index funds?

Post by Northern Flicker »

It would not be easy to identify the source of differences in return, but VLCAX has delivered about 22 bp/yr of additional return relative to VFIAX since inception of VLCAX:

http://quotes.morningstar.com/chart/fun ... 2%3A955%7D

https://www.portfoliovisualizer.com/bac ... ion2_2=100
Northern Flicker
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Re: Is there a point of "Peak Passive" with index funds?

Post by Northern Flicker »

This is not a very scientific test, but I compared the S&P and CRSP indices by backtesting a synthetic total market portfolio using funds for each family of indices. I included a single total market index fund as well. Note that despite the name, the CRSP small-cap Index is a market completion index for the large cap index.

I started with current market weight percentages for the large-cap and market completion funds, and adjusted the weights of the split portfolios to align variance with the total market fund. This is because the percentage of total market cap held by either large cap index can vary a little over time.

The point here is to remove any size factor effect differences between the S&P and CRSP large-cap indices and just look at the effect of where the split is made. The fund tracking the CRSP large-cap Index had an ER of .12% when introduced, so a higher bar to overcome.

https://www.portfoliovisualizer.com/bac ... tion5_3=12

Again, not a conclusive test, as there are other variables, not the least of which is that the split points are not fixed over time, but it suggests that the S&P500 could possibly be losing 9-12 bp/year to market trading issues.
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