How do index funds affect stock valuations?

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Esq123
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How do index funds affect stock valuations?

Post by Esq123 » Tue Aug 14, 2018 3:21 pm

Hey all-

Sorry if this has been discussed before or is not a good question- But my question here is does investing in an index fund in any way shape or form affect stock valuations?

So if I drop say 50-100k in an index fund will this have any affect on stock prices for the day?

In contrast, if I sell my entire portfolio of index funds will this in any way affect the market?

This is just something I thought about today.

Thank you.

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Re: How do index funds affect stock valuations?

Post by RadAudit » Tue Aug 14, 2018 3:57 pm

Esq123 wrote:
Tue Aug 14, 2018 3:21 pm
So if I drop say 50-100k in an index fund will this have any affect on stock prices for the day?
Generally accepted answer: No.
Esq123 wrote:
Tue Aug 14, 2018 3:21 pm
n contrast, if I sell my entire portfolio of index funds will this in any way affect the market?
Generally accepted answer: No.
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Re: How do index funds affect stock valuations?

Post by dm200 » Tue Aug 14, 2018 3:57 pm

Esq123 wrote:
Tue Aug 14, 2018 3:21 pm
Hey all-
Sorry if this has been discussed before or is not a good question- But my question here is does investing in an index fund in any way shape or form affect stock valuations?

So if I drop say 50-100k in an index fund will this have any affect on stock prices for the day?

In contrast, if I sell my entire portfolio of index funds will this in any way affect the market?


This is just something I thought about today.

Thank you.
Noise level - compared to the whole market activity in one day.

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Sandtrap
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Re: How do index funds affect stock valuations?

Post by Sandtrap » Tue Aug 14, 2018 4:03 pm

According to data, index funds make up 17.5 percent of the $67.9 trillion in global equity market capitalization.
It would take an unrealistic amount to move the bigger needle.
j

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arcticpineapplecorp.
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Re: How do index funds affect stock valuations?

Post by arcticpineapplecorp. » Tue Aug 14, 2018 5:09 pm

This is actually an interesting question and I'll attempt to answer it differently from the previous posters. The previous posters are saying you're too little a fish in too big a pond to affect stock prices. Along those lines, a big institutional investor (pension fund, mutual fund, etc.) could move stock prices but think about why and how it's different from what you're doing.

If Warren Buffett (or some other bigger fish than you) wants to place a huge trade he's doing something different from you...namely he's actually buying specific stocks (or shares if you want to be more precise. But even then, he may only be buying shares of ONE stock). You're not. You're buying an index fund that tracks an index (could be an entire market, or could be a part of the market like small cap value stocks only). In any event, you're not buying shares in actual stocks. You're buying shares in a mutual fund (index hopefully) that tracks the stocks in the underlying index (benchmark). Now the actual fund itself does own shares of stocks but you're not buying them, not directly anyway. You're an "indirect" buyer of stocks, whereas Warren is a "direct" buyer of stocks.

If Warren wants to buy enough shares he may have to be buying from multiple parties (i.e., he may not be able to get ALL the shares he wants from ONE other investor). Therefore he may be buying some shares at lower prices and other shares at higher prices and the fact that he needs to buy so many shares could mean that other investors might hold out to sell their shares until they get a higher price because they know how badly Warren wants/needs them. (not literally, but I believe it is known by traders, etc. when there's an unusually large buy order and as a result, some getting wind of a need for their shares will want to wait for a better price, which Warren will have to pay if he wants the shares badly enough).

Finally, and most importantly, when you issue an order to buy shares in your index fund (if done by 4 p.m.), you get whatever the price is of the fund at the end of the day. So you're not affecting the share prices because the share prices have already settled and you don't even know what you're paying until the market has already closed and the closing price of your index fund has been established.

All of this is not true of Index ETFs. With ETFs you are actually stating what price you want to buy your index ETF in real time (just like Warren does with individual stocks, because ETFs trade just like individual stocks). You're still not a big enough fish to affect the Index ETF price all by yourself.

A little more technical, but does that sort of answer your question?
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JoMoney
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Re: How do index funds affect stock valuations?

Post by JoMoney » Tue Aug 14, 2018 6:07 pm

The amount of money you're talking about, in an index fund (or any large cap stocks), would not have any noticeable impact on the market .

As to the 'big' traders, say a Warren Buffett, I've heard him mention that when he or his associates start making moves on a stock they'll do it over time, trading 5%-10% of the daily volume of whatever the market is trading to minimize there impact. For some 'large' stocks, like say IBM, the daily volume might be 3 million shares x $140 a share... so unless you're trading in the tens of millions of dollars on a single day in a single large stock, you probably don't have much to worry about.
If you start getting into thinly traded micro-cap stocks the situation is different.
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Re: How do index funds affect stock valuations?

Post by nisiprius » Tue Aug 14, 2018 6:16 pm

They cannot affect relative stock valuations because what you are buying or selling exactly matches the composition of the market. In theory, if you tried to buy a really enormous amount of an index fund--let's say an index ETF like VTI--there might not be enough stocks available at the current market price to fill your order, so you would have to raise your bid just a bit and your huge purchase would raise the price of all stocks.

But that would be absolutely no different from what happens if investors who are not using index funds get enthusiastic about stocks in general. The fact that you are using an "index fund" is irrelevant.
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Re: How do index funds affect stock valuations?

Post by triceratop » Tue Aug 14, 2018 6:24 pm

arcticpineapple's post is a good response for the market microstructure, and nisiprius' is also correct at a broader level. Let me get even more specific. Your question is essentially one of market impact. What does that mean? The reality is that there is not a single "price" that one has for a given trade. The average price anyone can expect to buy/sell at, at a particular time, depends both on (1) the quantity they wish to buy (2) the depth of liquidity there is for that security. This gets into something called an "order book", where basically, to first order, all interested parties and their buy/sell orders are put in a two-column table and ranked by price in each column. A market order to buy/sell then proceeds down the appropriate side of that book and is filled by matching to prices others are willing to transact at.

Here is an example of an order book:

Image

At the scale that any retail investor invests at, in broad market index funds (as oppposed to MSFT as displayed above), we won't impact the market much, neither through ETFs or mutual funds. Our trades are termed "uninformed", because they don't reflect any special knowledge other than establishing a position in line with market consensus.

By the way, Vanguard has a trading limit on their mutual funds to prevent mutual fund investors, who are guaranteed to receive the closing price (4pm EDT), from affecting the performance of the fund. This trading limit gives an idea of how to know if a given trade is expected to move the market. It isn't that Vanguard prohibits you from making the trade in the end, it's that they want to receive advance notice so that they can ensure the right liquidity is available for you and plan the trade for the fund. For Total Stock Market that limit is $5 million.

The contrast to Warren Buffett is straightforward. His trades are what are called "informed", i.e. his trades take a view on a stock. Not only that, but also, his trades move the price of the stock because of the volume he transacts in. This is not just because of the scale of cash he might deploy compared to a retail investors' trades, but also because he takes a concentrated position in a single security, so the market impact is focused on a single stock out of, say, the SP500 rather than the entire universe (again, say, the SP500). Say he wants to take a position in MSFT. If he wants a substantial number of shares he will need to move through the order book (on the right-hand side), driving up the ask price. That is market impact.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."


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Re: How do index funds affect stock valuations?

Post by jalbert » Tue Aug 14, 2018 8:12 pm

If you buy or sell shares of an index fund, the dollar volume is spread across the entire market in proportion to the free float, a measure of liquidity of all the stocks. If you buy or sell shares of all of the stocks in a non-index portfolio, some stocks must be overweighted in the portfolio by virtue of it not being an index portfolio. These stocks will be more impacted by the purchase or sale than any stock in a market index fund as a result.

As a degenerate case, consider if someone buys or sells 100K worth of shares of a market index fund vs 100K worth of shares of a microcap stock. Which will move the needle of any particular individual stock?
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Re: How do index funds affect stock valuations?

Post by triceratop » Tue Aug 14, 2018 8:30 pm

Phineas J. Whoopee wrote:
Tue Aug 14, 2018 8:00 pm
What if everybody indexed?
PJW
Although the topic title would seem to imply this google search is relevant to OP's question, it is in fact not.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

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Phineas J. Whoopee
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Re: How do index funds affect stock valuations?

Post by Phineas J. Whoopee » Wed Aug 15, 2018 6:34 pm

triceratop wrote:
Tue Aug 14, 2018 8:30 pm
Phineas J. Whoopee wrote:
Tue Aug 14, 2018 8:00 pm
What if everybody indexed?
PJW
Although the topic title would seem to imply this google search is relevant to OP's question, it is in fact not.
Thank you, triceratop.

I believe the fundamental error is supposing the accounting convention for stock prices is something other than the most recent transaction at an agreed-upon price between the most eager seller and the most eager buyer.

I explained stock market mechanics in the middle of this post. It's in a thread about the Efficient Market Hypothesis, but market mechanics are the same whether or not the EMH is true.

Any of us buying or selling an index fund does not change the calculations of the most eager buyer and the most eager seller.

PJW

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Re: How do index funds affect stock valuations?

Post by TomCat96 » Wed Aug 15, 2018 6:36 pm

Esq123 wrote:
Tue Aug 14, 2018 3:21 pm
Hey all-

Sorry if this has been discussed before or is not a good question- But my question here is does investing in an index fund in any way shape or form affect stock valuations?

So if I drop say 50-100k in an index fund will this have any affect on stock prices for the day?

In contrast, if I sell my entire portfolio of index funds will this in any way affect the market?

This is just something I thought about today.

Thank you.
You could buy or sell a thousand times that amount and it wouldn't affect anything beyond noise levels.

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BeBH65
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Re: How do index funds affect stock valuations?

Post by BeBH65 » Thu Aug 16, 2018 10:11 am

It is my understanding that many of the fund transactions do not lead to actual transactions of the underlying stocks.
The "baskets" of the sellers are transferred to the buyers. This is very explicit with Etf's.
Only when there is in-balance between the amount of sales and buys will be a "primary" transaction.

Apparently 5% of the daily transaction volume involves index funds.
Reference: http://www.etf.com/sections/features-an ... nopaging=1
Hougan: Is indexing too big?
[Vanguard CEO Tim] Buckley: The short answer is no, not by a long shot. There are misleading but headline-grabbing statistics quoted in the media all the time, but the reality is that indexing represents about 15% of the value of all global equities and less than 5% of global fixed-income assets. Much of the anti-indexing rhetoric comes from varied sources who’ve felt their revenue decline with indexing’s rise.

I strongly disagree with the assertions on indexing size and undue influence on the financial markets and in boardrooms. Our research shows that index funds make up less than 5% of daily trading volume. [emphasis added] As such, there’s considerable price discovery and liquidity provided by active strategies.

There are also unfounded assertions that index fund managers stifle competition and conspire to keep prices high. Vanguard and other index providers are active and engaged on the corporate governance front, and promote good stewardship practices and healthy competition among portfolio companies.
BeBH65. (only an investment enthusiast, not a financial adviser, perform your due diligence).

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Re: How do index funds affect stock valuations?

Post by bogleVB » Fri Aug 17, 2018 9:48 am

Long time lurker who's entire portfolio changed according to the information I learned here and disseminate to my offspring. Thanks all to this incredible resource.

I'm not satisfied with the practical answers thus far, all too realworldish small fish in a big pond for me and the general theory of how this works. Yeah, real world 100k is nothing to an index and volume of trade in a given day but...

You put in a buy order on the index, if that buy order is enough to make the index need to buy at least one share of a particular stock to maintain the appropriate %'s then the index put's in a buy order on a stock and...
-That stock has a current price
-If an owner of that stock is willing to meet that buy order at the current price, there is no impact.
-If no owner of the stock is willing to meet that buy order at the current price, the stock price goes up.

Stock prices go up and down due to buy and sell orders all the time, this is the price fluctuations of the trading. Stock price influences valuation.

Now say someone meets the buy order at the current price so the price didn't change. But someone walks in behind you with a buy order which does not get met at the current price...feels like your buy order impacted the likelihood of a price+valuation change too.

I suppose the index could maintain the %'s by selling other shares, but then you get the same answers in reverse.

amIwrong?

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arcticpineapplecorp.
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Re: How do index funds affect stock valuations?

Post by arcticpineapplecorp. » Fri Aug 17, 2018 8:14 pm

welcome to the group and thanks for posting. I'm going to add/correct a couple things (as I see it) you said (I'm no expert):
bogleVB wrote:
Fri Aug 17, 2018 9:48 am
You put in a buy order on the index, if that buy order is enough to make the index need to buy at least one share of a particular stock to maintain the appropriate %'s then the index put's in a buy order on a stock and...
But there are so many people buying and selling that it's quite possible no shares have to be bought/sold by the mutual fund. All that happens is shares of the fund exchange hands. Like as a non retired person, when I buy shares in my Vanguard fund, I could be buying them from my mom who, as a retiree, is selling her shares. No need for Vanguard to sell/buy any actual stock shares.
bogleVB wrote:
Fri Aug 17, 2018 9:48 am
-That stock has a current price
-If an owner of that stock is willing to meet that buy order at the current price, there is no impact.
-If no owner of the stock is willing to meet that buy order at the current price, the stock price goes up.
The stock price doesn't go up just because no one is willing to sell their stock to interested buyers. That's like saying "There were more buyers of stocks today than sellers". There are always an equal number of buyers and sellers because for every seller there has to be one buyer.

What is more accurate to say is, "If no owner of the stock is willing to meet that buy order at the current price...then an interested buyer would have to offer a higher price to entice the holder of the stock to actually sell it to the interested buyer."

So the price doesn't just go up because someone doesn't want to sell. It goes up because a buyer offers a higher price (than current) and the seller agrees to sell at the higher price being offered.
bogleVB wrote:
Fri Aug 17, 2018 9:48 am
Stock prices go up and down due to buy and sell orders all the time, this is the price fluctuations of the trading. Stock price influences valuation.
I'm not sure that's right (I could be wrong). I think that the reason stock price goes up is because people are offering higher prices...because they value the future prospects of the stock more favorably than previous stock buyers did. Usually, this is because new information came out (earnings, favorable tax law changes, etc.) that show the company to be likely to be more profitable in the near future than it was in the past.

By that definition it's not the stock price that influences valuation. It's the valuation of the company that determines the stock price. This is true if you believe in EMH.

Thoughts?
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Re: How do index funds affect stock valuations?

Post by bogleVB » Mon Aug 20, 2018 9:16 am

Yeah, when the owners of the stock being purchased are not willing to meet the current price, the price goes up, is what I was getting at.

While I did say "if that buy order is enough to make the index need to buy at least one share of a particular stock to maintain the appropriate %'s", you make a good point about I may be buying the index and someone else may be selling the index thus there's not a direct "must go out and purchase some google today" due to the index purchase order. Did some quick googling, cause I'm no expert in these matters and am always learning, and it appears to be pretty decoupled. Different funds do it differently but an index may rebalance "quarterly/semi-annually etc" so yeah, your purchase order gets aggregated into potentially months of buy/sell orders of the index and then dealt with in bulk. My resistance to smallfishism is futile lol. At least one thing I read made me think that there are also rebalancing bands to make the index go buy/sell earlier then the routine rebalance, but that would take huge market swings or a warren buffet times 1000 sized buy order.

Maybe I'm confusing the "rebalancing" with the index's general volume of stocks they must own based on the amount of money in the index???? Even if the index is only rebalancing once a quarter, don't they still need to go buy/sell to keep their volume right? Again, I'm learning here.

Does the stock price itself influence valuation? Well, again quick google reveals many different valuation techniques, at least some of them factor in current stock price, so it depends on what method you are using.

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