Do Buy & Hold Index Investors "need" people to actively invest?
Do Buy & Hold Index Investors "need" people to actively invest?
Theoretical question: Do buy and hold index investors need other investors to pick individual stocks/invest in actively managed funds in order to get returns? In other words if everyone decided to index...would there be a marketplace?
Re: Do Buy & Hold Index Investors "need" people to actively invest?
Yes, index investors need active investors because active investors set the prices.. they "decide" GOOG is worth $500 or whatever so they set bids at $499 and asks at $501 and wait for people to accept those offers. Passive investors accept whatever those offers are by policy.
If there's ever a problem with not enough active investors, you'll know because the 'spread' between bid and ask becomes large. That spread is the 'take' active investors demand in exchange for their service of setting prices. Since there are far more active investors than the market needs right now, the 'take' is tiny.
If there's ever a problem with not enough active investors, you'll know because the 'spread' between bid and ask becomes large. That spread is the 'take' active investors demand in exchange for their service of setting prices. Since there are far more active investors than the market needs right now, the 'take' is tiny.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
To add some nuance to what Tamalak said, it is trading that sets prices, not ownership. There are billions of dollars of trades every market day. If these trades stopped, there would be no “price” for a given stock (and thus for all stocks).
My position is, that if things actually went so far towards indexing as to reduce market efficiency (my standard would be when over 50% of actively managed mutual funds outperformed their respective index on the SPIVA scorecard) that I would get back into the stock picking game. So your scenario will never happen because of me and other like-minded people.
My position is, that if things actually went so far towards indexing as to reduce market efficiency (my standard would be when over 50% of actively managed mutual funds outperformed their respective index on the SPIVA scorecard) that I would get back into the stock picking game. So your scenario will never happen because of me and other like-minded people.
It's not an engineering problem - Hersh Shefrin | To get the "risk premium", you really do have to take the risk - nisiprius
Re: Do Buy & Hold Index Investors "need" people to actively invest?
In a pedantic answer limited just to actively managed mutual funds: NO. There is absolutely no “need” for actively managed mutual funds to exist (and at one point in history, they didn’t). There is a need for transactions in the individual securities - individual companies. But if 100% of mutual funds went “index”, the system would work fine.
Last edited by David Jay on Mon Jun 03, 2019 10:19 am, edited 2 times in total.
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Re: Do Buy & Hold Index Investors "need" people to actively invest?
In a sense, there should be a broader version of efficient market hypothesis that says that if passive is much better than active, money flows into passive until they equalize in returns. (This happened in past decades; Bogle and others identified the inefficiency).
If too much money in passive, active becomes better, so more active trading.
In the future, they'll likely end up similar as far as returns go.
If too much money in passive, active becomes better, so more active trading.
In the future, they'll likely end up similar as far as returns go.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
Good point. In a more applicable sense though, given the balances invested in funds as opposed to individual complete shares stocks, if all "funds" were index, and the only other option was individual shares of stock, would that cause issue?David Jay wrote: ↑Mon Jun 03, 2019 10:07 amIn a pedantic answer to actively managed mutual funds: NO. There is absolutely no “need” for actively managed mutual funds to exist (and at one point in history, they didn’t). There is a need for transactions in the individual securities - individual companies. But if 100% of mutual funds went “index”, the system would work fine.
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Re: Do Buy & Hold Index Investors "need" people to actively invest?
Right, an important point that often gets overlooked in this discussion. Even if half the market is owned by indexers (in red), active market participants are still doing more than 90% of the trading (given the turnover assumptions below), since their turnover rate is so much higher. Indeed, if 90% of the market in indexed, active investors will still be doing more than 50% of the trading.
NOTE: Assumes active turnover is 100% annually and passive is 10%.
Source: Chart adapted from S&P-Dow Jones.
Last edited by SimpleGift on Mon Jun 03, 2019 12:17 pm, edited 1 time in total.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
Not at all. Remember, it is not “balances” or holdings that matter for setting prices. It is the active traders who are setting prices. The current price for Exxon is the last trade made this morning. The current price is not affected in the slightest by how many shares of Exxon is held by individuals mutual funds. Price is established by the most recent trade.coachd50 wrote: ↑Mon Jun 03, 2019 10:17 amGood point. In a more applicable sense though, given the balances invested in funds as opposed to individual complete shares stocks, if all "funds" were index, and the only other option was individual shares of stock, would that cause issue?David Jay wrote: ↑Mon Jun 03, 2019 10:07 amIn a pedantic answer to actively managed mutual funds: NO. There is absolutely no “need” for actively managed mutual funds to exist (and at one point in history, they didn’t). There is a need for transactions in the individual securities - individual companies. But if 100% of mutual funds went “index”, the system would work fine.
Last edited by David Jay on Mon Jun 03, 2019 11:16 am, edited 1 time in total.
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Re: Do Buy & Hold Index Investors "need" people to actively invest?
There is a continual flow of posts worrying about this issue.
Personally I have a strong belief that there is an infinite reservoir of people who will believe they are smarter than the market.
Personally I have a strong belief that there is an infinite reservoir of people who will believe they are smarter than the market.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
Hey, I used to be one of thoseadamthesmythe wrote: ↑Mon Jun 03, 2019 11:11 amPersonally I have a strong belief that there is an infinite reservoir of people who will believe they are smarter than the market.
It's not an engineering problem - Hersh Shefrin | To get the "risk premium", you really do have to take the risk - nisiprius
Re: Do Buy & Hold Index Investors "need" people to actively invest?
I have seen estimates out there that only 20% of the market needs to be active to keep the markets efficient. It may not even be that much. Not only that, a lot of the "passive" investments are factor driven, they are a step beyond passive but they aren't active either. Factor investing by itself will do a lot to keep markets efficient and we haven't even talked yet about the hedge funds. Plus I don't think active mutual funds will disappear, though this part of the investment world will continue to shrink. So I wouldn't worry about this.
A fool and his money are good for business.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
Plus there will always remain a huge financial incentive to sell people actively managed services, to reap higher fees.adamthesmythe wrote: ↑Mon Jun 03, 2019 11:11 am Personally I have a strong belief that there is an infinite reservoir of people who will believe they are smarter than the market.
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Re: Do Buy & Hold Index Investors "need" people to actively invest?
Let's say we do. Why would it matter?
When I go to the supermarket, I pay whatever is marked on the price tag. I don't try to haggle price at the checkout counter.
I don't go down my shopping list and write down all of the prices in a little notebook, then drive two miles from the Safeway to the Food City, check the prices there, buy everything that's cheaper at Food City at Food City, then drive back to the Safeway and get the rest. (And that doesn't even get into the problem of whether Food Club cheese is better or worse than Lucerne Farms cheese).
I am free-riding on the people who comparison shop, and the professionals in the supermarket chains who negotiate prices with suppliers.
I am "a price taker, not a price maker."
I bet that well over 99% of grocery shoppers do what I do.
Does the system collapse? Should I feel guilty? Should I stop going to stores that use price tags and only patronize stores where I can haggle and participate in the grocery price discovery process?
What does it matter, except as a completely irrelevant bad-sounding thing that can be said about indexers?
When I go to the supermarket, I pay whatever is marked on the price tag. I don't try to haggle price at the checkout counter.
I don't go down my shopping list and write down all of the prices in a little notebook, then drive two miles from the Safeway to the Food City, check the prices there, buy everything that's cheaper at Food City at Food City, then drive back to the Safeway and get the rest. (And that doesn't even get into the problem of whether Food Club cheese is better or worse than Lucerne Farms cheese).
I am free-riding on the people who comparison shop, and the professionals in the supermarket chains who negotiate prices with suppliers.
I am "a price taker, not a price maker."
I bet that well over 99% of grocery shoppers do what I do.
Does the system collapse? Should I feel guilty? Should I stop going to stores that use price tags and only patronize stores where I can haggle and participate in the grocery price discovery process?
What does it matter, except as a completely irrelevant bad-sounding thing that can be said about indexers?
Last edited by nisiprius on Tue Jun 04, 2019 5:33 am, edited 1 time in total.
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.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
"index investors need active investors because active investors set the prices"
Don't the index funds take their cash inflows and buy the individual stocks in their index? So isn't the index fund just one of the buyers of individual stocks that sets prices?
Don't the index funds take their cash inflows and buy the individual stocks in their index? So isn't the index fund just one of the buyers of individual stocks that sets prices?
Re: Do Buy & Hold Index Investors "need" people to actively invest?
One “problem” that may be created by too much index investing is that index funds must by shares of all companies in the index regardless of the performance of those companies. So if a company in the index is doing poorly there may be an “artificial” demand for that stock that props up its price.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
As has been mentioned, for price discovery people do need to be able to purchase individual stocks. However, the one thing I've been theorizing on is the effects of index funds on liquidity and how that effects the price fluctuations of individual stocks. Index buy and hold investing removes liquidity from the market. The shares in index funds just stay put, they are not contributing to the market price fluctuations (aside from share lending of course, but these are a minority of shares in an index fund). What this does though is almost provide the effect of reducing the float. There are less shares available for trading, so each individual stock trade has increased effect on price. The larger the market cap, the more index funds hold of the specific companies shares, and the more pronounced the effect (could be a large contributor in why small and value factors have been underperforming through the last decade or two of strong increasing momentum towards index funds). That's my theory at least. It will be interesting to see the side effects of this going forward in the future as indexing continues to trend up in popularity. This is a topic that I personally find very interesting. Every action has and equal and opposite reaction, and we are still kind of trying to figure out what these reactions of index fund popularity truly are.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
you don't need any trading at all to own stocks. too few people have ever held a thinly traded stock... the primary problem with that is when you DO want to sell, transaction fees are quite high. other than that, it doesn't matter. the business still does its thing, and you still own it. kind of puts all the endless discussions of correlation, standard deviation, etc into context.
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Re: Do Buy & Hold Index Investors "need" people to actively invest?
No, this is not true. If the shares of a company do poorly the index fund does not need to do anything it all. It does not need to buy more shares, nor does it need to sell shares. It just continues to hold the same number of shares. If the stock used to be 2% of the index, and the price of its shares drops to half of what it was, then the stock now becomes 1% of the index. And the shares that the index fund holds lose half their value, and automatically--with no action needed at all--now become worth 1% of the fund's value.RAchip wrote: ↑Tue Jun 04, 2019 12:20 pm One “problem” that may be created by too much index investing is that index funds must by shares of all companies in the index regardless of the performance of those companies. So if a company in the index is doing poorly there may be an “artificial” demand for that stock that props up its price.
Also, no, an index fund is not required to replicate the index. That's up to the fund and the fund's chosen rules. An index fund simply promises to match the performance of the index, not the detailed composition of the index. An index fund can defer purchases of a stock and, instead, buy other stocks that are generally similar in characteristics and behavior. The Vanguard 500 Index Fund launched with something like 275 stocks in its portfolio.
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.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
Let's not forget that even with the S&P 500 index, there are literally dozens of ways to invest in that index.
I count over 50 unique "S&P 500 " indexes: S&P 500 Ex-Health Care Index, S&P 500 Low Volatility Rate Response Index, S&P 500 Equal Weight Telecommunication Services & Utilities Index, S&P 500 High Beta Index, S&P 500 Buyback Index, S&P 500 Catholic Values Index, S&P 500 Pure Value Index, S&P 500 Fossil Fuel Free Index, and so on.
So-called "index investors" have multiple ways to set prices on individual stocks within the S&P 500 using nothing but off-the-shelf ETFs.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
Re: Do Buy & Hold Index Investors "need" people to actively invest?
Umm, so what does the Vanguard S&P 500 index fund do when it gets new money? It gets lots of new money every day. Does it not buy the S&P 500 losers so it can outperform the S&P 500?nisiprius wrote: ↑Tue Jun 04, 2019 1:58 pmNo, this is not true. If the shares of a company do poorly the index fund does not need to do anything it all. It does not need to buy more shares, nor does it need to sell shares. It just continues to hold the same number of shares. If the stock used to be 2% of the index, and the price of its shares drops to half of what it was, then the stock now becomes 1% of the index. And the shares that the index fund holds lose half their value, and automatically--with no action needed at all--now become worth 1% of the fund's value.RAchip wrote: ↑Tue Jun 04, 2019 12:20 pm One “problem” that may be created by too much index investing is that index funds must by shares of all companies in the index regardless of the performance of those companies. So if a company in the index is doing poorly there may be an “artificial” demand for that stock that props up its price.
Also, no, an index fund is not required to replicate the index. That's up to the fund and the fund's chosen rules. An index fund simply promises to match the performance of the index, not the detailed composition of the index. An index fund can defer purchases of a stock and, instead, buy other stocks that are generally similar in characteristics and behavior. The Vanguard 500 Index Fund launched with something like 275 stocks in its portfolio.
From the VG S&P 500 fund summary prospectus: “The Fund attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the Index, holding each stock in approximately the same proportion as its weighting in the Index.” So when it gets new money it buys shares of the companies in the index in proportion to how they are represented in the index.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
It should buy the losers and the winners proportionally to the market. It is not the goal of an S&P 500 index fund to outperform the S&P 500. Instead the goal is to replicate the performance of the index as good as possible.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
Exactly. So the claim that “If the shares of a company do poorly the index fund does not need to do anything it all. It does not need to buy more shares, nor does it need to sell shares“ is just plain false. The index gets new money constantly and so needs to buy the stocks in the index. That buying happens without any consideration whatsoever as to how the companies are actually performing thus propping up the price of companies that are actually performing poorly. This works in reverse as well during downturns when money is pulled from the index—they are forced to sell all stocks, even those doing well thus driving down prices of otherwise more valuable stocks.
Re: Do Buy & Hold Index Investors "need" people to actively invest?
If one index fund is buying a stock on the market from an index fund who is selling how do they determine the price at which they will buy/sell (imagine the market is composed entirely of that single trade or imagine many index funds trading between each other.)?
Re: Do Buy & Hold Index Investors "need" people to actively invest?
A market-cap weighted index fund buys and sells all stocks with the same proportion as in the market. There shouldn't be any distortion of the relative prices.RAchip wrote: ↑Wed Jun 05, 2019 6:41 amExactly. So the claim that “If the shares of a company do poorly the index fund does not need to do anything it all. It does not need to buy more shares, nor does it need to sell shares“ is just plain false. The index gets new money constantly and so needs to buy the stocks in the index. That buying happens without any consideration whatsoever as to how the companies are actually performing thus propping up the price of companies that are actually performing poorly. This works in reverse as well during downturns when money is pulled from the index—they are forced to sell all stocks, even those doing well thus driving down prices of otherwise more valuable stocks.
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Re: Do Buy & Hold Index Investors "need" people to actively invest?
If you wish to argue that e.g. the collective actions of 401(k) participants, blindly buying stocks every month regardless of price, is driving up the market as a whole and making the entire market overpriced, OK. But that has nothing to do with index funds. In fact, it is just the opposite. The more these blind stock buyers choose total market index funds, the less distortion they will create in the stock market.
If they choose to blindly invest in Fidelity Contrafund, they will selectively drive up the prices of Wil Danoff's favorite stocks.
If they choose to blindly invest in DFA Small Cap Value Portfolio, they will selectively drive up the prices of small cap value stocks.
But if they choose to blindly invest in a total stock market index fund, they will not be favoring any category of stock over any other.
If someone goes into a pot of soup and fishes out all the dumplings, it changes the composition of the soup and makes it worse for anyone following who wants dumplings. But if someone goes into a pot of soup, mixes it thoroughly, and draws out a ladleful that is an accurate sample of the soup as a whole, the soup left in the pot is just the same as before, no better and no worse.
If they choose to blindly invest in Fidelity Contrafund, they will selectively drive up the prices of Wil Danoff's favorite stocks.
If they choose to blindly invest in DFA Small Cap Value Portfolio, they will selectively drive up the prices of small cap value stocks.
But if they choose to blindly invest in a total stock market index fund, they will not be favoring any category of stock over any other.
If someone goes into a pot of soup and fishes out all the dumplings, it changes the composition of the soup and makes it worse for anyone following who wants dumplings. But if someone goes into a pot of soup, mixes it thoroughly, and draws out a ladleful that is an accurate sample of the soup as a whole, the soup left in the pot is just the same as before, no better and no worse.
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.