Podcast:Randolph Cohen & Michael Green: How Concerned Should We Be About Index Funds?

[valleyrock]

I'm not sure if a thread has started on this most recent Rational Reminder podcast. (Episode 332 - Randolph Cohen & Michael Green: How Concerned Should We Be About Index Funds?, Nov 21, 2024, https://rationalreminder.ca/podcast/332).

There was an earlier thread discussing Green's appearance there on the same issue. But now they brought in Randy Cohen from Harvard to more or less debate, or discuss the issues here with Green. The earlier thread is here: viewtopic.php?t=430546 .

The discussion was civil. I got about half way through it before deciding I need help understanding this. There are a lot of points here, and, apparently, no conclusions were reached, according to what was said in the introduction.

Among ideas I think I've absorbed so far, Green is saying that things have changed, largely because now institutions are basically required to put employees' retirement funds into 60-40 index funds. This drives up the price of the most expensive stocks, he says, by reducing their volatility (and so less risky, and so their values go up). Cohen argues that these moneys were going into 60-40 funds anyway, before it because the default approach. Green thinks that one upshot is that stocks are overvalued substantially, by as much as 50%, IIRC. Cohen disagrees. They got into a discussion of present values of these investments, with Green saying they increase at x 1.06 (approximately) each year, with Cohen arguing that the 6% factor has a certain half life, so it's x 1.06 the first year, and then it goes down each year.

Green argues that indexing, while good for individuals, has a societal cost. Money might otherwise go to helping local communities, for example, he says.

It's complicated because these guys are well read and refer to some of the literature, and have different interpretations of that literature.

I'm hoping that the cognoscetti here can distill this discussion down into an answer(s) to the basic question: is there anything actionable here, and, if so, what, and why?

[bh1]

It is intuitive to me that indexing increases volatility. Since that is the opposite of the claim above, maybe the effect on volatility is less than obvious?

My logic is that indexing is equivalent to leveraging all non-indexed trades. That cranks volatility up. Am I wrong?

(Example: Say 50% of the stock is indexed. Selling a share would result in twice the movement than without indexing, since an indexed mirror share was also sold.)

[Gaston]

I'm hoping that the cognoscetti here can distill this discussion down into an answer(s) to the basic question: is there anything actionable here, and, if so, what, and why?

Michael Green first appeared on the Rational Reminder podcast in episode 302. In that episode, when asked what the individual investor should do, his response was “For the average investor investing in Vanguard funds, nothing. You keep investing in index funds.”

[Northern Flicker]

is there anything actionable here[/u], and, if so, what, and why?

It is actionable for me-- I actively ignore Michael Green. I don't consider his arguments to be valid.

[valleyrock]

It is intuitive to me that indexing increases volatility. Since that is the opposite of the claim above, maybe the effect on volatility is less than obvious?

My logic is that indexing is equivalent to leveraging all non-indexed trades. That cranks volatility up. Am I wrong?

(Example: Say 50% of the stock is indexed. Selling a share would result in twice the movement than without indexing, since an indexed mirror share was also sold.)

I think he's saying that with so much indexing, with the indexes purchasing stocks on a market capitalization basis, the prices of the high market cap stocks are going to go upward the most, others less so. That seems intuitive. This kind of axiomatic increase in prices lowers volatility, which, according to theory, lowers risk. On the other hand, things seem riskier when the prices are driven up, not by fundamentals of the businesses, but by this guaranteed purchasing of the securities. Not that I understand a lot of this. And we'll understand matters much better in 25 years, as one of them points out in the podcast(!)

Good it's been pointed out that there's nothing actionable here according to the proponent of this thinking. If that's the case, then we can I suppose relax and leave the discussions to others. OTOH, there will likely be some responses to this podcast and the accompanying ideas by academics and others who've studied the literature these guys understand. So it might be helpful to keep our ears to the ground.

[dkturner]

is there anything actionable here[/u], and, if so, what, and why?

It is actionable for me-- I actively ignore Michael Green. I don't consider his arguments to be valid.

Of course there is. If you buy Green’s argument you can move your indexed investments to active managers who have lower allocations to large capitalization equities (think mid-cap or small-cap oriented managers). You can also lower your allocation to equities in general, or embrace “value” oriented equities, or some combination of the two.

As to the “why”, it’s obvious that IF equities are 50% overvalued, a smaller allocation to equities reduces the risk of loss. Seems actionable to me.

[bh1]

It is intuitive to me that indexing increases volatility. Since that is the opposite of the claim above, maybe the effect on volatility is less than obvious?

My logic is that indexing is equivalent to leveraging all non-indexed trades. That cranks volatility up. Am I wrong?

(Example: Say 50% of the stock is indexed. Selling a share would result in twice the movement than without indexing, since an indexed mirror share was also sold.)

I think he's saying that with so much indexing, with the indexes purchasing stocks on a market capitalization basis, the prices of the high market cap stocks are going to go upward the most, others less so. That seems intuitive. This kind of axiomatic increase in prices lowers volatility, which, according to theory, lowers risk. On the other hand, things seem riskier when the prices are driven up, not by fundamentals of the businesses, but by this guaranteed purchasing of the securities. Not that I understand a lot of this. And we'll understand matters much better in 25 years, as one of them points out in the podcast(!)

Good it's been pointed out that there's nothing actionable here according to the proponent of this thinking. If that's the case, then we can I suppose relax and leave the discussions to others. OTOH, there will likely be some responses to this podcast and the accompanying ideas by academics and others who've studied the literature these guys understand. So it might be helpful to keep our ears to the ground.

Cap-weighted investing is the only allocation that doesn't affect the relative prices of stocks. After adding more index funds, the market as a whole goes up, but the relative weightings of the stocks remained the same.

Seems like the entire point of this podcast is to obfuscate, not clarify.

[FundQuant]

Green's argument is an extreme assumption of inefficient markets. Do index funds brainlessly drive up prices in a manner that the rest of the market doesn't properly account for? I don't see the evidence to support this claim. For example, why have European stocks lagged US stocks so badly despite the growth of index funds there? Why have tech stocks in the USA outperformed the rest of the index by so much? There are logical and empirical answers to these questions that aren't consistent with the theory that index funds mindlessly drive up prices. The tech sector alone debunks this nonsense view because tech has fundamentally outperformed everything. Their extraordinary growth is consistent with their booming EPS. And the rest of the index (and global equities) have lagged for fundamental reasons.

Index funds work. They're working exactly as we'd expect them to and high fee fund managers criticizing them should be ignored.

[Trance]

Considering Americans can barely afford to retire even with these investments, I think its fine. If anything I want to see more people investing for retirement

[Northern Flicker]

It is actionable for me-- I actively ignore Michael Green. I don't consider his arguments to be valid.

Of course there is. If you buy Green’s argument you can move your indexed investments to active managers who have lower allocations to large capitalization equities (think mid-cap or small-cap oriented managers). You can also lower your allocation to equities in general, or embrace “value” oriented equities, or some combination of the two.

As to the “why”, it’s obvious that IF equities are 50% overvalued, a smaller allocation to equities reduces the risk of loss. Seems actionable to me.

What that is acting on is the weighting of megacaps in indices, not on Mr. Green's argument. Index funds buy stocks in proportion to their liquidity. That should not be responsible driving up the prices of megacaps.

[arcticpineapplecorp.]

I'm hoping that the cognoscetti here can distill this discussion down into an answer(s) to the basic question: is there anything actionable here, and, if so, what, and why?

the argument is that index funds are either making the market less efficient or driving up prices.

But index funds aren't price makers. They're price takers. Index funds don't set the prices. They have to buy at the market price. Individual traders are setting the prices (this could be individual investors, hedge fund managers, active managed mutual fund managers, endowment fund managers or pension fund managers).

These individuals are deciding the prices of the stocks that make up the market.

If the price is wrong, then won't the traders eventually get to the "right" price? (and then indexers benefit as a result).

if so, then how is it that the index is distorting those prices? The index is reflecting the prices already determined by the traders.

[Halicar]

Green argues that indexing, while good for individuals, has a societal cost. Money might otherwise go to helping local communities, for example, he says.

I'm struggling to see the connection here. What money? The management fees?

[Beensabu]

Cap-weighted investing is the only allocation that doesn't affect the relative prices of stocks.

It supports the price.

[bh1]

Cap-weighted investing is the only allocation that doesn't affect the relative prices of stocks.

It supports the price.

Sorry, but I can't turn that into anything meaningful. What do you mean by 'support'? The price of what?

[Beensabu]

It supports the price.

Sorry, but I can't turn that into anything meaningful. What do you mean by 'support'? The price of what?

Inflows into broad market index funds support the price of the stocks held by those funds.

[bh1]

Sorry, but I can't turn that into anything meaningful. What do you mean by 'support'? The price of what?

Inflows into broad market index funds support the price of the stocks held by those funds.

What does 'support' mean? Can you add some math to this concept?

[grabiner]

Inflows into broad market index funds support the price of the stocks held by those funds.

What does 'support' mean? Can you add some math to this concept?

Here, it means to increase demand, but it affects all stocks equally because the funds hold them all. Markets match supply and demand, and price goes up when demand increases.

If shoppers want to buy more turkey and less beef, the price of turkey will go up relative to beef. If investors want to buy a larger share of Microsoft than of Ford, the price of Microsoft will go up relative to Ford; however, that isn't what happens when indexers hold the same share of both Microsoft and Ford. (Rather, it is what happens when investors want to sell Ford at the current market price and buy Microsoft, which is what many non-index investors do.)

[bh1]

What does 'support' mean? Can you add some math to this concept?

Here, it means to increase demand, but it affects all stocks equally because the funds hold them all. Markets match supply and demand, and price goes up when demand increases.

If shoppers want to buy more turkey and less beef, the price of turkey will go up relative to beef. If investors want to buy a larger share of Microsoft than of Ford, the price of Microsoft will go up relative to Ford; however, that isn't what happens when indexers hold the same share of both Microsoft and Ford. (Rather, it is what happens when investors want to sell Ford at the current market price and buy Microsoft, which is what many non-index investors do.)

Agreed. But there is an implication above (in the podcast?) that larger companies are somehow "supported" more than smaller ones.

[grabiner]

Here, it means to increase demand, but it affects all stocks equally because the funds hold them all. Markets match supply and demand, and price goes up when demand increases.

If shoppers want to buy more turkey and less beef, the price of turkey will go up relative to beef. If investors want to buy a larger share of Microsoft than of Ford, the price of Microsoft will go up relative to Ford; however, that isn't what happens when indexers hold the same share of both Microsoft and Ford. (Rather, it is what happens when investors want to sell Ford at the current market price and buy Microsoft, which is what many non-index investors do.)

Agreed. But there is an implication above (in the podcast?) that larger companies are somehow "supported" more than smaller ones.

And I don't agree with that implication. (In theory, there might be an effect when corporations join the S&P 500, because a lot of index money is linked to that index, but there wouldn't be an effect between different corporations in the S&P 500.)

[Beensabu]

But there is an implication above (in the podcast?) that larger companies are somehow "supported" more than smaller ones.

They're supported in proportion to their share of market capitalization.

[bh1]

But there is an implication above (in the podcast?) that larger companies are somehow "supported" more than smaller ones.

They're supported in proportion to their share of market capitalization.

As they should be. Index funds maintain the relative capitalization of companies, and thus have no direct effect on relative stock prices.

[valleyrock]

Considering Americans can barely afford to retire even with these investments, I think its fine. If anything I want to see more people investing for retirement

Good point. Many Americans' only source of retirement income is Social Security.

[Northern Flicker]

Sorry, but I can't turn that into anything meaningful. What do you mean by 'support'? The price of what?

Inflows into broad market index funds support the price of the stocks held by those funds.

The same proportion of 401K inflows would flow into stocks whether or not index funds were in the plans to receive them, and in aggregate across all 401K participants they would look a lot like the market index either way.

[firebirdparts]

It is intuitive to me that indexing increases volatility. Since that is the opposite of the claim above, maybe the effect on volatility is less than obvious?

My logic is that indexing is equivalent to leveraging all non-indexed trades. That cranks volatility up. Am I wrong?

You are 100% right. Indexing increases volatility because half the stock is owned by people who won't trade on price. This is fundamental.

Fund inflows and outflows are very real, but you've noticed that for the last 40 years, people, even people who think they're geniuses, get hooked into this idea that it's all inflows and that's all we need to ever talk about.

refusing to trade based on price wouldn't necessarily drive prices "up". There are clearly two possibilities. To me, anybody who says there is more money going into stocks because of indexing is just not very smart. He may have a Nobel prize, I don't care. That's not smart.

The increase in money going into the stock market has almost nothing to do with indexing. Lots of factors, but not that.

[JustGotScammed]

I'm not sure if a thread has started on this most recent Rational Reminder podcast. (Episode 332 - Randolph Cohen & Michael Green: How Concerned Should We Be About Index Funds?, Nov 21, 2024, https://rationalreminder.ca/podcast/332).

There was an earlier thread discussing Green's appearance there on the same issue. But now they brought in Randy Cohen from Harvard to more or less debate, or discuss the issues here with Green. The earlier thread is here: viewtopic.php?t=430546 .

The discussion was civil. I got about half way through it before deciding I need help understanding this. There are a lot of points here, and, apparently, no conclusions were reached, according to what was said in the introduction.

Among ideas I think I've absorbed so far, Green is saying that things have changed, largely because now institutions are basically required to put employees' retirement funds into 60-40 index funds. This drives up the price of the most expensive stocks, he says, by reducing their volatility (and so less risky, and so their values go up). Cohen argues that these moneys were going into 60-40 funds anyway, before it because the default approach. Green thinks that one upshot is that stocks are overvalued substantially, by as much as 50%, IIRC. Cohen disagrees. They got into a discussion of present values of these investments, with Green saying they increase at x 1.06 (approximately) each year, with Cohen arguing that the 6% factor has a certain half life, so it's x 1.06 the first year, and then it goes down each year.

Green argues that indexing, while good for individuals, has a societal cost. Money might otherwise go to helping local communities, for example, he says.

It's complicated because these guys are well read and refer to some of the literature, and have different interpretations of that literature.

I'm hoping that the cognoscetti here can distill this discussion down into an answer(s) to the basic question: is there anything actionable here, and, if so, what, and why?

People mindlessly buy stocks in the index, artificially lifting their prices. This eventually produces losses. On the other hand, people mindlessly sell stocks that get kicked out of the index, artificially lowering their prices. This eventually produces gains. If you want to outperform the market, the actionable advice is to create your own index of companies kicked out of the index.

https://fortune.com/2024/08/18/beat-sp5 ... 1000-nixt/

[hnd]

He addressed this on another podcast...maybe it was on the compound and friends. The larger issue is that index funds are becoming "non diversified" (at least large cap ones) and can be by rule. whereas many active funds are bound by diversification rules. But I think Josh Browns argument was funds being "non diversified" vs "diversified" used to be a much bigger deal than it is today. Fidelity has begun making a number of their funds "non diversified" so it can follow index trends to keep up.

But the larger point of the conversation was that total market or market representative (whether you are talking about total US, SP500, or total World) still only makes up a fraction of the overall equity investing world and therefore this is something that might require regulatory addressing at some point but otherwise there isn't much actionable things for the every day investor to do.

[Beensabu]

refusing to trade based on price wouldn't necessarily drive prices "up"

It still supports the price, though.

It's not that it drives the price "up"; it keeps the price from going "down" below a certain level.

When you get fund outflows, the support is removed.

[Northern Flicker]

refusing to trade based on price wouldn't necessarily drive prices "up"

It still supports the price, though.

It's not that it drives the price "up"; it keeps the price from going "down" below a certain level.

When you get fund outflows, the support is removed.

When sellers/selling outpace buyers/buying for the stocks in the market, the support is removed. The cash flows for particular funds/containers of those stocks is not what matters.

[Beensabu]

The cash flows for particular funds/containers of those stocks is not what matters.

It does when the containers hold the majority of outstanding shares.

[Northern Flicker]

The cash flows for particular funds/containers of those stocks is not what matters.

It does when the containers hold the majority of outstanding shares.

Even leaving aside the fact that they don't hold a majority, it still is a red herring. When a large number of investors want to get out of stocks, they sell broadly, whether in index funds, individual stocks, or other types of funds. The aggregate mix being sold off across all of these investments will look a lot like a market index even with a low share in index funds.

[Beensabu]

Even leaving aside the fact that they don't hold a majority, it still is a red herring.

They do in aggregate, across brokerages.

The aggregate mix being sold off across all of these investments will look a lot like a market index even with a low share in index funds.

Totally.

It's not an index fund thing.

It's a 401k contributions into aggressive asset allocations thing.

[Northern Flicker]

Even leaving aside the fact that they don't hold a majority, it still is a red herring.

They do in aggregate, across brokerages.

Numbers I've seen are several years old, but had about 25% of free float indexed. Mutual funds and ETFs are not the whole market.

[Beensabu]

hey do in aggregate, across brokerages.

Numbers I've seen are several years old, but had about 25% of free float indexed. Mutual funds and ETFs are not the whole market.

Free float is non-institutionally held shares. Mutual funds are institutional ownership.

[Northern Flicker]

Numbers I've seen are several years old, but had about 25% of free float indexed. Mutual funds and ETFs are not the whole market.

Free float is non-institutionally held shares. Mutual funds are institutional ownership.

Free float does not exclude institutional ownership. It excludes shares that cannot be sold without some restriction being cleared.

Some info:

https://corporatefinanceinstitute.com/r ... ree-float/

[Beensabu]

Free float is non-institutionally held shares. Mutual funds are institutional ownership.

Free float does not exclude institutional ownership. It excludes shares that cannot be sold without some restriction being cleared.

Some info:

https://corporatefinanceinstitute.com/r ... ree-float/

I stand corrected. Thank you.

It doesn't matter at all that the index fund share of the US market is currently a bit over 50% (80% of which is held by three firms) or that mutual funds with low turnover are long-term holders of shares that trade rarely. There is absolutely nothing to see here.

[Northern Flicker]

Free float does not exclude institutional ownership. It excludes shares that cannot be sold without some restriction being cleared.

Some info:

https://corporatefinanceinstitute.com/r ... ree-float/

I stand corrected. Thank you.

It doesn't matter at all that the index fund share of the US market is currently a bit over 50%...

That also is false. Index funds may have 50% of mutual fund and ETF assets, but not 50% of the US market, which is much deeper than just what is in funds.

[Beensabu]

That also is false. Index funds may have 50% of mutual fund and ETF assets, but not 50% of the US market, which is much deeper than just what is in funds.

Thanks for that correction as well.

Looks like institutions (which includes more than mutual funds and ETFs) hold 80% of US equity market cap. Unless that is also false? Feel free to let us know if so.

[Northern Flicker]

The size of the institutionally held share of the market does not help confirm or disaffirm Mr. Green's point.

[Beensabu]

The size of the institutionally held share of the market does not help confirm or disaffirm Mr. Green's point.

Really? I thought his point was about price blind buying in combination with long-term holding causing a market distortion.

[Northern Flicker]

The size of the institutionally held share of the market does not help confirm or disaffirm Mr. Green's point.

Really? I thought his point was about price blind buying in combination with long-term holding causing a market distortion.

The institutional share of the market is neither the share of the market held by mutual funds and ETFs nor the share of the market that is indexed. Institutional holdings are both indexed and active. About 25% of the market was indexed in 2019. I have not seen 2024 numbers, but there still should leave about 75% to do price discovery and arbitrage away mispricings.

[Beensabu]

Really? I thought his point was about price blind buying in combination with long-term holding causing a market distortion.

The institutional share of the market is neither the share of the market held by mutual funds and ETFs nor the share of the market that is indexed. Institutional holdings are both indexed and active. About 25% of the market was indexed in 2019. I have not seen 2024 numbers, but there still should leave about 75% to do price discovery and arbitrage away mispricings.

And what percentage of non-indexed institutional investments are internally indexed or closet indexed?

Passive investing is not just index funds.

[Northern Flicker]

The institutional share of the market is neither the share of the market held by mutual funds and ETFs nor the share of the market that is indexed. Institutional holdings are both indexed and active. About 25% of the market was indexed in 2019. I have not seen 2024 numbers, but there still should leave about 75% to do price discovery and arbitrage away mispricings.

And what percentage of non-indexed institutional investments are internally indexed or closet indexed?

Passive investing is not just index funds.

If someone wants to claim that passive investing is hampering price discovery, they need to present solid evidence of that, not speculations of behavior with varying levels of generality. I would suggest that you try to answer your own questions to see where it leads rather than asking others to analyze whether the speculations have any merit.

If market participants know of mispricings, they will arbitrage them away rapidly. If mispricings are present, but unknown, active management does not help the investor.

[Beensabu]

If someone wants to claim that passive investing is hampering price discovery, they need to present solid evidence of that, not speculations of behavior with varying levels of generality.

Passive Investing and the Rise of Mega-Firms - https://www.nber.org/system/files/worki ... w28253.pdf

US Equities: Approaching Peak Passive and the Implications for Active - https://www.man.com/maninstitute/us-equities

[Northern Flicker]

If someone wants to claim that passive investing is hampering price discovery, they need to present solid evidence of that, not speculations of behavior with varying levels of generality.

Passive Investing and the Rise of Mega-Firms - https://www.nber.org/system/files/worki ... w28253.pdf

That states that passive investing was 54% of investment fund products, but only 16% of the market in 2021. The claim that this is enough to distort pricing and/or increase volatility of megacaps is interesting. I still would expect there to be market participants trying to exploit that and prices to be brought back in line rapidly. Maybe it is worth it for 401K contributions to land in a money market fund, and be invested say 2 weeks later. I'm skeptical that would make a measurable difference.

[Beensabu]

If market participants know of mispricings, they will arbitrage them away rapidly. If mispricings are present, but unknown, active management does not help the investor.

When there's a wave breaking over you, you either let it crash on you, ride it, or dive under it.

Shorting momentum to the upside is the crash; closet indexing is the ride; skipping the action is diving through.

Only one of these options keeps inflows coming.

[Northern Flicker]

If market participants know of mispricings, they will arbitrage them away rapidly. If mispricings are present, but unknown, active management does not help the investor.

When there's a wave breaking over you, you either let it crash on you, ride it, or dive under it.

Shorting momentum to the upside is the crash; closet indexing is the ride; skipping the action is diving through.

Only one of these options keeps inflows coming.

We don't know that indexing in 401Ks is having any effect whatsoever. 401K contributions would be flowing into stocks, and in aggregate would look a lot like a market index even if index funds were not used. In aggregate, we might even see more funds not less flowing to large caps without indexing in use.