Do Index Funds Overvalue the S&P 500?

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Oddibe McDowell
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Do Index Funds Overvalue the S&P 500?

Post by Oddibe McDowell » Mon Jun 29, 2020 5:11 pm

I'm sure this has been asked before but I'm wondering if any of you can help me understand this.

I get the Efficient Market Theory (I think). I've been in Vanguard Total Stock Market Index for years. I've read several of Jack Bogle's books and understand he thinks there is very little difference in the S&P 500 and the Total Market over the long term. My two investing heroes are Bogle and Warren Buffett. As we all know, Buffett tends to recommend the S&P 500 (but in my opinion doesn't ever explain why or if he prefers that to Total Market).

I've been contemplating a switch to the S&P (for a number of reasons), but started thinking about it. If the S&P funds all have to buy the stocks that are chosen by Standard & Poohs to be in the index, are their values not inflated by the fact that so many are buying shares automatically? Does the Efficient Market Theory mean that in theory, other shareholders (not in S&P funds) would sell if any particular company was overvalued? I suppose the same could be true of total market but it seems like the would be more of a risk with the S&P unless I'm looking at it wrong - which I'm sure I am!

I hope my question makes sense and would love for someone to tell me where I'm looking at it wrong.

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anon_investor
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Re: Do Index Funds Overvalue the S&P 500?

Post by anon_investor » Mon Jun 29, 2020 5:46 pm

Oddibe McDowell wrote:
Mon Jun 29, 2020 5:11 pm
I'm sure this has been asked before but I'm wondering if any of you can help me understand this.

I get the Efficient Market Theory (I think). I've been in Vanguard Total Stock Market Index for years. I've read several of Jack Bogle's books and understand he thinks there is very little difference in the S&P 500 and the Total Market over the long term. My two investing heroes are Bogle and Warren Buffett. As we all know, Buffett tends to recommend the S&P 500 (but in my opinion doesn't ever explain why or if he prefers that to Total Market).

I've been contemplating a switch to the S&P (for a number of reasons), but started thinking about it. If the S&P funds all have to buy the stocks that are chosen by Standard & Poohs to be in the index, are their values not inflated by the fact that so many are buying shares automatically? Does the Efficient Market Theory mean that in theory, other shareholders (not in S&P funds) would sell if any particular company was overvalued? I suppose the same could be true of total market but it seems like the would be more of a risk with the S&P unless I'm looking at it wrong - which I'm sure I am!

I hope my question makes sense and would love for someone to tell me where I'm looking at it wrong.
Total Stock Market and S&P500 perform nearly identical long term. If you already have Total Stock Market I would not bother switching.

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Re: Do Index Funds Overvalue the S&P 500?

Post by retired@50 » Mon Jun 29, 2020 5:56 pm

If I recall correctly, Jeremy Siegel mentions the short term price movements of firms as they join or leave the S&P 500 in his book "Stocks For The Long Run". Maybe read that book if you're interested in knowing more of the details he uncovered.

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This is one person's opinion. Nothing more.

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nisiprius
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Re: Do Index Funds Overvalue the S&P 500?

Post by nisiprius » Mon Jun 29, 2020 7:07 pm

Oddibe McDowell wrote:
Mon Jun 29, 2020 5:11 pm
...As we all know, Buffett tends to recommend the S&P 500 (but in my opinion doesn't ever explain why or if he prefers that to Total Market)....
That is my opinion about Buffett's recommendation, too.

With regard to your main point, you may have been infected, directly or at second or third-hand, by propaganda from anti-indexers, who like to bring this up. If there is an effect, it is so small that there is an argument about whether it really exists.

One important point which anti-indexers sometimes misrepresent, is that index funds are not required to replicate their index exactly, nor are they required to buy stocks on the exact day when they are added. They can make guesses, add stocks early or late, or use statistical combinations of other stocks if they think one stock in the index is misbehaving.

In any case, if it is an important effect, we would expect it to show up in a comparison between IWB, which tracks the Russell 1000, and VOO, which tracks the S&P 500. The Russell 1000 simply includes the thousand largest stocks, without regard to whether they meet S&P 500 criteria like being "leading companies in leading industries" or having an accumulated profit over four consecutive quarters.

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Re: Do Index Funds Overvalue the S&P 500?

Post by firebirdparts » Mon Jun 29, 2020 7:29 pm

Oddibe McDowell wrote:
Mon Jun 29, 2020 5:11 pm
I hope my question makes sense and would love for someone to tell me where I'm looking at it wrong.
You are thinking about it exactly right. When you buy, somebody has to be convinced to sell (based on price). That's true if you buy through a mutual fund. There is an effect of companies coming in and out of the 500. Supply and demand for that stock will certainly be affected. I don't readily know what fraction of the shares would need to change hands, but the fraction is basically the same for any company. Probably 10-20%. I looked but not sure; there are lots of values given for the amount of US equities owned by all passive funds combined, but I was looking specifically for S&P500 index funds.

Of course, the effect on the fund shareholder is pretty dull. There is a much larger effect, in my opinion, of people saying "I think the market's going down, I'll sell everything". You have to convince somebody to buy when you think the market's going down.
A fool and your money are soon partners

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Oddibe McDowell
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Re: Do Index Funds Overvalue the S&P 500

Post by Oddibe McDowell » Mon Jun 29, 2020 7:55 pm

nisiprius wrote:
Mon Jun 29, 2020 7:07 pm
Oddibe McDowell wrote:
Mon Jun 29, 2020 5:11 pm
...As we all know, Buffett tends to recommend the S&P 500 (but in my opinion doesn't ever explain why or if he prefers that to Total Market)....
That is my opinion about Buffett's recommendation, too.

With regard to your main point, you may have been infected, directly or at second or third-hand, by propaganda from anti-indexers, who like to bring this up. If there is an effect, it is so small that there is an argument about whether it really exists.

One important point which anti-indexers sometimes misrepresent, is that index funds are not required to replicate their index exactly, nor are they required to buy stocks on the exact day when they are added. They can make guesses, add stocks early or late, or use statistical combinations of other stocks if they think one stock in the index is misbehaving.

In any case, if it is an important effect, we would expect it to show up in a comparison between IWB, which tracks the Russell 1000, and VOO, which tracks the S&P 500. The Russell 1000 simply includes the thousand largest stocks, without regard to whether they meet S&P 500 criteria like being "leading companies in leading industries" or having an accumulated profit over four consecutive quarters.

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Thank you Nisiprius. I don’t post often but have enjoyed and learned from your posts over the years. Thanks for your contributions to the forum!

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Re: Do Index Funds Overvalue the S&P 500?

Post by RTF » Mon Jun 29, 2020 8:12 pm

nisiprius wrote:
Mon Jun 29, 2020 7:07 pm
Oddibe McDowell wrote:
Mon Jun 29, 2020 5:11 pm
...As we all know, Buffett tends to recommend the S&P 500 (but in my opinion doesn't ever explain why or if he prefers that to Total Market)....
That is my opinion about Buffett's recommendation, too.

With regard to your main point, you may have been infected, directly or at second or third-hand, by propaganda from anti-indexers, who like to bring this up. If there is an effect, it is so small that there is an argument about whether it really exists.

One important point which anti-indexers sometimes misrepresent, is that index funds are not required to replicate their index exactly, nor are they required to buy stocks on the exact day when they are added. They can make guesses, add stocks early or late, or use statistical combinations of other stocks if they think one stock in the index is misbehaving.

In any case, if it is an important effect, we would expect it to show up in a comparison between IWB, which tracks the Russell 1000, and VOO, which tracks the S&P 500. The Russell 1000 simply includes the thousand largest stocks, without regard to whether they meet S&P 500 criteria like being "leading companies in leading industries" or having an accumulated profit over four consecutive quarters.

Source
Image

Could it possibly be the fact that Buffet doesn’t buy into the mass diversification that others (JB) do? I remember seeing a video/interview with Buffet where he essentially said that total diversification just wasn’t needed. His AA he’s suggested is pretty aggressive, perhaps he doesn’t want the small/mid caps included as well.

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Oddibe McDowell
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Re: Do Index Funds Overvalue the S&P 500?

Post by Oddibe McDowell » Mon Jun 29, 2020 8:22 pm

RTF wrote:
Mon Jun 29, 2020 8:12 pm
nisiprius wrote:
Mon Jun 29, 2020 7:07 pm
Oddibe McDowell wrote:
Mon Jun 29, 2020 5:11 pm
...As we all know, Buffett tends to recommend the S&P 500 (but in my opinion doesn't ever explain why or if he prefers that to Total Market)....
That is my opinion about Buffett's recommendation, too.

With regard to your main point, you may have been infected, directly or at second or third-hand, by propaganda from anti-indexers, who like to bring this up. If there is an effect, it is so small that there is an argument about whether it really exists.

One important point which anti-indexers sometimes misrepresent, is that index funds are not required to replicate their index exactly, nor are they required to buy stocks on the exact day when they are added. They can make guesses, add stocks early or late, or use statistical combinations of other stocks if they think one stock in the index is misbehaving.

In any case, if it is an important effect, we would expect it to show up in a comparison between IWB, which tracks the Russell 1000, and VOO, which tracks the S&P 500. The Russell 1000 simply includes the thousand largest stocks, without regard to whether they meet S&P 500 criteria like being "leading companies in leading industries" or having an accumulated profit over four consecutive quarters.

Source
Image

Could it possibly be the fact that Buffet doesn’t buy into the mass diversification that others (JB) do? I remember seeing a video/interview with Buffet where he essentially said that total diversification just wasn’t needed. His AA he’s suggested is pretty aggressive, perhaps he doesn’t want the small/mid caps included as well.
Yeah, I’ve wondered that. He’s never really said as far as I can tell.

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Re: Do Index Funds Overvalue the S&P 500?

Post by JoMoney » Mon Jun 29, 2020 8:50 pm

Several years back Ben Stein did an interview with Buffett, and Stein did bring up Total Stock Market, or at least "VTI" (the ticker for Vanguard's Total Stock Market ETF).
https://web.archive.org/web/20190122225 ... n.fortune/
... What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?

"Equities," Buffett answers without a moment's hesitation.

"The VTI?" I ask.

"That's good enough. Maybe a selection of high-dividend-paying stocks that are likely to raise their dividends. Maybe the top 100 dividend payers of the S&P 500."

Then, after a second's thought, he adds, "Well, maybe not that, but equities." ...
The way I hear/read Buffett's response is effectively to suggest that any reasonably diversified assortment of stocks should do fine. An index fund is just a very low cost simple way to do that. I just don't see him quibbling about which broad-market average is best at capturing the average. Pick the index you want to track, we know the one Buffett picked for his hedge fund bet and bequest for his wife. Pick the one you like, and just stick with it.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Do Index Funds Overvalue the S&P 500?

Post by Aleph » Tue Jun 30, 2020 5:36 am

I'm no expert on this, but I wonder if the real issue is not so much index funds per se, as total funds being invested in the S&P500 (or any index / asset class)? Active managers of funds with a stated aim to invest in large cap US stock are also buying into these companies "automatically", just with more discretion over which ones to pick.

If the total amount of funds being saved by the US (or world) population and invested into US large cap, index funds or not, increases substantially, wouldn't that have to drive up equities prices? And if so, would that be an unjustified increase / a bubble?

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Re: Do Index Funds Overvalue the S&P 500?

Post by nisiprius » Tue Jun 30, 2020 8:03 am

Here's my own point of view. My original reason for buying the Vanguard S&P 500 Index Fund was "I don't want to pick stocks." At that time, everyone thought of the S&P 500 as "the market." Rolf Banz had published his 1981 paper on the small-firm effect, but I didn't know anything about it. I'd heard of the Wilshire 5000 index but it was sort of weird, it wasn't a mainstream thing. Vanguard's Total Stock Market Index Fund existed and tracked the Wilshire 5000, but it was new, not well-known, and had a noticeably higher expense ratio.

Later on, for whatever reason--possibly a Vanguard blurb?--I noticed that the Vanguard Total Stock Market Index Fund had the same expense ratio as the Vanguard 500 Index, and eventually I switched, not because I thought it was better, but because it was more faithful to my plan. I wanted "not to pick stocks at all." The Total Market fund was closer to "not picking stocks at all" than the 500 Index.

I never believed and still don't believe that it makes much difference. The 500 Index includes 80% of the market and what it leaves out has had an 87% correlation to what it includes, so adding that other 20% can't possibly make much difference. And if you seriously want small-caps, you want far more than you get in Total Stock, so regardless of whether you use 500 Index or Total Stock, you need to add an additional fund anyway.

Now, as for Buffett, OK, let me play the Buffettology game. 2016 shareholder letter, on p. 24, he said:
Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.
I can interpret this as saying "If I advise people to use a low-cost S&P 500 index fund, they may really do it. If I suggest anything even slightly more complicated, they probably won't. I will do the greatest good for the greatest number by recommending the S&P 500." If you like "a low-cost S&P 500 index fund" is the "elevator pitch."
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Re: Do Index Funds Overvalue the S&P 500?

Post by hulburt1 » Tue Jun 30, 2020 8:49 am

S&P has made me a millionaire so that what I stick with. 67 and still 70% S&P.

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Re: Do Index Funds Overvalue the S&P 500?

Post by Silk McCue » Tue Jun 30, 2020 8:57 am

hulburt1 wrote:
Tue Jun 30, 2020 8:49 am
S&P has made me a millionaire so that what I stick with. 67 and still 70% S&P.
Earning an income and faithful investing is the primary reason you are a millionaire. The S&P is just a supporting character in the success.

Cheers

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