The Impact of Index Investing: A Follow-Up

http://www.philosophicaleconomics.com/2016/05/followup/

by tosseraccount • 10 years ago

115 129 10 years ago

philosophicaleconomics.com

atemerev• 10 years ago

Passive investing is popular when markets are good. And there wasn't any significant crisis since 2008-2009.

When markets make a downturn, passive investing is not a great idea.

toth• 10 years ago

That's true, but it's also true if you drop the "passive" part :)

nabla9• 10 years ago

Buying index funds in downturns provides more ling term value than buying the same index fund when markets are good.

ryangittins5• 10 years ago

When the market takes a dive is the best time to invest in index funds. The problem comes when people panic and pull out their money in a recession, realizing the loss. If the market rebounds you come out ahead and if it doesn't, you've got much bigger problems.

The best policy is to put money in the market every month, through the best and worst of it, especially if you're young.

paganel2• 10 years ago

The problem comes when people panic and pull out their money in a recession,

This doesn't happen only because of panic.

In a recession, by definition, bad things happen: people lose cushy jobs, they end up uninsured just before an illness happens, very close relatives (parents, kids) fall on hard times them-selves and you have to bail them out etc etc. All these new problems require liquidity, which can be very easily obtained by selling your stocks, even if at a loss. Multiply this across the whole middle-class and the end-result won't be pretty.

JamilD5• 10 years ago

I was at the Berkshire meeting this past weekend, and Buffett gave a nice (if simplified) explanation of investing in index funds over active investment, as it pertains to hedge funds, hiring analysts, etc.

An excerpt from the transcript [0] follows:

What I’d like you to do is for a moment, imagine that in this room, you people own all of America. All the stocks in America are owned by this group. You are the Berkshire 18,000 (or whatever it is) that have somehow managed to accumulate all the wealth in the country. Let’s assume we just divide it down the middle. On one side, we put half the people…half of all the investment capital in the world, and that capital is what a certain presidential candidate might call ‘low energy’. In fact, they have no energy at all. They buy half of everything that exists in the investment world – 50 percent – everyone on this side. Now half of it is owned by these ‘low energy’ people. They don’t look at stock prices. They don’t turn on business channels. They don’t read the Wall Street Journal. They don’t do anything. They are a slovenly group that just sits for year after year, owning half of America’s business. What’s the result going to be? The result is going to be exactly average as all American business does because they own half of all of it. They have no expenses – nothing.

What’s going to happen with the other half? The other half are what we call the ‘hyperactives’. The hyperactives’ gross result is also going to be half, right? The whole has to be the sum of the parts. This group, by definition, can’t change from its half of the ultimate investment results. This half is going to have the same gross results. They’re going to have the same results as the ‘no energy’ people but they’re also going to have terrific expenses because they’re all going to be moving around, hiring hedge funds, hiring consultants, and paying lots of commissions, et cetera. As a group, that half has to do worse than this half does. The people who don’t do anything have to do better than the people that are trying to do better. It’s simple.

[0] https://www.biznews.com/global-investing/2016/05/02/berkshir...

IanCal2• 10 years ago

This can cause an interesting dilemma if you assume that what people invest in makes a difference to the output.

It may make more sense selfishly to be in the low-energy group, but the overall returns might be lower the more people go that route.

A flawed car analogy: A driver and passenger will both travel the same distance, but the driver spends a lot more effort per mile.

So it might both be better for each individual to be low-energy yet better for everyone if people were more active.

It's an interestingly complex problem.

sp332• 10 years ago

The passive side gets the same results as the active side (before fees), but the active side determines what the result will be.

e12e4• 10 years ago

Interesting analogy. I'd say that trains and buses are generally better than cars: arguably we do better with higher efficiency (less effort for similar gain). Why would making "more effort" be better for the value of stocks, if the net result is the same? I would like to think that it is CEOs and boards that manage companies actively, not investors that simply want a certain ROI.

In your analogy, I'd say investors are car leasing companies, and it's unclear if they provide a value that can't be just as well provided by the driver(s) buying their cars outright. It would mean that the driver(s) would have to be on more equal footing to the investors, though (they'd have to be able to afford the car).

marcosdumay2• 10 years ago

Interestingly, the more bad (under average) investors move to passive investment, the better the average outcome will get. And the more good (above average) investors move there, the worse it'll become.

All counted, isn't it great when incentives align almost perfectly with the global optimum?

roymurdock4• 10 years ago

This is the danger of only considering averages. Everyone on the passive side gets whatever return the market dictates. In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns.

Different individuals on the active side have wildly differing returns. The guy who invests in the hedge fund with 200% returns doesn't care about the 20, 2 fee structure he has to pay on his investment because he's made so much more than the passive guys. There will be large losers and large winners, but you have to pay table stakes (fees) to play and have your shot at winning those big returns.

Buffet is talking his book - a hugely diversified portfolio that basically represents and relies on the strength and growth of the American economy, as well as US government-mandated oligopolies like insurance.

matt_wulfeck3• 10 years ago

I hear this mentioned "hedge funds are for downturns" but why is it that hedges were getting demolished going into 2016? If they really do better in downturns then I would have expected better performance from hedge funds as a whole.

JamilD5• 10 years ago

In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns.

This was the argument made by Protege Partners, when betting against Buffett in the great "index funds vs hedge funds" long bet [0]. It turns out that the index funds fared better — and they're mainly used for long-term investment, where the short-term macroeconomic ebbs don't have an impact on the overall return.

Of course the variance on the active side will be higher, but there are as many losers as they are winners, and much of it is due to simple randomness. Unless you're confident that you know more than other investors (for many people, including myself, we probably don't [1]), index funds, or "hugely diversified portfolios" are the way to go. Basically, no hedge fund is making those 200% returns you're speaking of, and even if some fund were, empirically it's more likely to be just noise. Look at the result so far of Buffett's bet on hedge funds. It speaks volumes.

[0] http://longbets.org/362/

[1] https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effec...

briHass2• 10 years ago

This is basically a restating of William Sharpe's famous 1991 paper that basically started the whole discussion.

"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

When someone picks active management over passive, they are really betting that they can beat, and hence are not, average. It's difficult for people to swallow their hubris, even when simple arithmetic shows them that they are (collectively) wrong.

http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7

lintiness3• 10 years ago

when someone picks active management over passive, they're betting THEIR MANAGER can beat the average. people invested in buffett's stock picking skill; how are they doing?

pbreit5• 10 years ago

That may be true that the "average" actively dollar will underperform but it should be easy (or at least possible) to identify the "above average" actively managed dollar.

aakilfernandes2• 10 years ago

The key (absurd) assumption is that 100% of assets are passively-investable.

hsitz• 10 years ago

No, the hypothetical assumes that 50% of all assets are passively-investable. 50% low-energy, 50% high-energy. There are a lot of brilliant, resourceful people in that high energy crowd who are establishing the share prices that the low-energy crowd then gets to take advantage of for nothing. High-energy percentage could likely be much, much less than 50% and passive investing would still work.

There is no real danger that so many people are going to turn passive that it won't work; there are plenty of people out there who think they can do better (and always will be, given human nature), despite the evidence that they won't.

RockyMcNuts• 10 years ago

Well he does say "To be clear, I’m not arguing that an entire market could ever go passive."

Which kinds of begs the question, how much passive investment can there be, and what is the limiting factor, if not a Grossman-Stiglitz model where 'arbitrage ' (in this context market-making, market-timing etc.) makes prices boundedly efficient, and less arbitrage means higher spreads, less liquidity, less pricing efficiency.

There must be a 'Bernstein peak' and mixed strategy equilibrium, where if you have too much active, expenses are too high, and if you have too little active, liquidity suffers and costs from spreads and volatility are too high.

http://abnormalreturns.com/2016/02/19/the-bernstein-curve/

lintiness3• 10 years ago

it's worth noting that buffett doesn't believe markets are "efficient":

"[D]iversification is protection against ignorance. It makes little sense if you know what you are doing."

joncrocks• 10 years ago

Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices?

If you own all of the stock in the US, and no-one actively trades in any single stock, how do you know how much one sort of stock is worth against another piece of stock?

I think this eventually drives trading of individual stocks, as the market looks to set prices/trade things this that it thinks are over/under valued.

So I think that it's true that on average an active investor will make less money than a passive one, it's the active one's doing the work/generating the value, as well as giving money to the passive investors!

(presuming rational actors, laws are obeyed etc etc)

jcdavis• 10 years ago

Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices?

If this stuff interests you, I recommend reading the previous post (http://www.philosophicaleconomics.com/2016/05/passive/), which discusses this exact topic.

dragonwriter6• 10 years ago

Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices?

There is no "correct" price aside from the price set through the market.

pbreit5• 10 years ago

I think you're right that there would be a natural balancing. If too many passive dollars went into certain companies, they should become more clearly over-valued than a peer not in the index.

drumdance5• 10 years ago

When people withdraw money from an index fund -- say, to put a downpayment on a house or move it into a fixed income fund for retirement -- they are effectively placing a sell order on every stock in the index.

And if they put money in from their monthly paycheck, they're placing a buy order.

As long there is a reasonably good balance of buyers and sellers of mutual funds, the underlying securities will find equilibrium.

KKKKkkkk1• 10 years ago

Brilliant. Only a person of the caliber of Buffett can get away with repeating what has been common knowledge since the 1970s and is nowadays written in pretty much every financial self-help book to a rapt audience who record his every word and quote him on Internet forums.

JamilD5• 10 years ago

He's not claiming it's new information or something only he knows. In fact he attributes most of his knowledge to Graham.

Read some of the other comments in this thread and you'll see it's not common knowledge either.

drumdance5• 10 years ago

Index funds were scorned for many years. The first index fund was started by John Bogle in 1976, but he had a difficult time attracting investors. They didn't really become popular until the nineties.

This Planet Money episode talks about it in detail.

http://www.npr.org/sections/money/2016/03/04/469247400/episo...

polskibus• 10 years ago

Wouldn't that be true iif all investing was zero sum game? As far as I know it isn't, at least not in equities.

Dolores12• 10 years ago

He implies that market will always grow. Lets say we have Japanese market. How do you make money here?

tonyedgecombe• 10 years ago

Dividends?

dragonwriter6• 10 years ago

The fundamental flaw in that argument is the assumption that the inactive and the active groups share of ownership remains the same. Which it would have to only if:

(1) the initial split was formed by splitting each company into halves between the two groups, and

(2) no new companies were ever formed, or, if they are, they are from initiation split ownership exactly 50/50 between actives and inactives.

bhewes• 10 years ago

So the tortoise and the hare fable caste as passive vs active investors.

matt_wulfeck3• 10 years ago

I love passive investing (vanguard admiral shares anyone??) but there are several things that I find lacking:

1. It's really boring. There's no earnings to follow, no products to watch, etc

2. You can't get rich from most indexes. The risk and reward is too low. It's unlikely to invest in a index that gives you a 10x return, though it does happen.

In the end I keep the bulk in a low fee composite index but I like to speculate with a little, even if I invariably lose money on the spec part. It's more fun.

nfriedly• 10 years ago

I'd argue that you can get rich, just slowly.

bonniemuffin• 10 years ago

If you want "fun investing", go to Vegas. I personally don't think of investing as a source of entertainment.

matt_wulfeck3• 10 years ago

I quite enjoy listening to the conference call for a company. It really does tell you a lot about what's happening behind the scenes, and before anyone else knows it. It's like the company telling you little secrets :-)

savanaly3• 10 years ago

Investing in specific companies rather than indexes (which I assume is what everyone means by "fun investing"?) isn't very much like gambling in Vegas. With gambling in vegas you have a negative expected return with a high variance. With stock picking you have a positive expected return with a high variance (where do index funds fit in? positive expected return with low-ish variance).

Although picking stocks is still not rational if your only concern is your long run wealth, it's not irrational for the same reason as gambling. It's bad because you have the same expected return as low cost index funds, and you exert effort or pay fees for the privilege. That doesn't mean I look down on everyone who actively invests though-- they may have good reason to think they are special and can pick stocks better than average or they may just enjoy it, as the person to whom you responded said he did. And then it would be rational to actively invest at least some of the time.

baccredited• 10 years ago

I do the same. I take 10% of total net worth and invest wherever the hell I want. I call it my 'casino fund'.

For me I don't care about #2. If you had the most boring investment in the world that returned exactly 7% every single year I would put 90% of my assets there immediately. But I'd keep trying to beat that 7% in my casino fund.

tosseraccount2• 10 years ago

It's unlikely to invest in a index that gives you a 10x return.

Average return from S&P500 from 1928-2015 is 11.41% [ source : http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/... ]

Note that this is not inflation adjusted; inflation is about 3.4% historically.

It'd take a little over 21 years to get a nominal 10x return at 11.4% average return.

ultramancool2• 10 years ago

Yeah, this is basically why passive is great. People say hedge funds are good in a downturn, but the odds of a downturn in any given year are not actually that high.

ultramancool2• 10 years ago

Put 95% or so in passive, then use the rest for a few gambles. If you lose it all, no big deal, make sure you're comfortable writing it off. This way you can get the entertainment value, playing extremely risky with this money but without taking on much large scale risk. You can use leverage or options trading to maximize the risk/return for this if it doesn't feel like it's enough to be fun.

Some people say lottery tickets are the highest risk portion of the portfolio, but for people who like looking at numbers as you're describing, I think this is a better option.

bradleyjg• 10 years ago

If you have higher appetite for risk, take an efficient portfolio and lever it up to your desired risk level.

aakilfernandes2• 10 years ago

The main problem I have with index funds is the otherwise financially savyy people who tell me that index funds will get you on average x% a year. No! Index funds, in the past, gave x% a year. However past performance is not a predictor of future performance.

There is no law of physics/economics that says the S&P500 has to rise at x% a year on average.

lintiness3• 10 years ago

on top of that, the entire argument is predicated on us stock returns over a 100-150 year time period (an unusual one at that). what's the real expected investment life of the audience? the sample is ridiculously small.

tanderson923• 10 years ago

It sounds like your problem may be forming your opinion of index funds based on the comments of people who are not financially savvy. Extrapolating an opinion about people who you admit are not financially savvy to the question of whether the financial products themselves are a good investment doesn't make too much sense to me.

mac01021• 10 years ago

Past performance should be a predictor of future performance if the forces driving the market remain similar to the forces driving it in the past.

If they are not the same, then past performance may be a very bad predictor. But even in that case it is hard to imagine I'd do better by picking individual stocks unless I start researching companies as a full-time job.

shostack• 10 years ago

Here's what I haven't found a good answer to yet...

What is the risk when a large percentage of the middle class and others are all in low fee index funds?

This seems on the surface to be ripe for exploitation in some way, or like we'd be all exposed to the same black swan event and thus potentially trigger another major market event simply because everyone is in the same funds.

I am not a super educated investor so if this is impossible due to the nature of indexes please correct me, but I can't help but feel that this push towards the Bogleheads approach may have the unintended side effect of proverbially putting "all of our investors in one basket."

What are the risks if main street investors truly do shift to this style of investing en masse? It seems that the investments of our middle class and upper middle class would all take big hits at the same time which could cripple the nation moreso than if people were in other investments.

Again, I'm probably missing something here so would appreciate being educated on why my fears are invalid. I haven't been able to find any info on this from googling.

JamilD5• 10 years ago

Index funds expose you to essentially the entire market; it's the sum of thousands of tiny pieces of businesses all across America. We're not putting all our eggs in one basket, rather, we're all distributing them across many.

If you can pick an investment that will weather an economic downturn, and still provide a decent return — let me know, because I want to get in on it ;)

fdsaaf3• 10 years ago

But when everyone invests in everything equally, we all end up investing in nothing!

pbreit5• 10 years ago

Except the biggest index by far is only 500 of the companies, not even remotely "the entire market".

fdsaaf3• 10 years ago

The risk worries me too. Look at it this way: the whole purpose of a market is to allocate capital to productive ends. If everyone invests in index funds, market capitalization (and thus capital allocation) becomes a function of inertia and ceases to have anything to do with actual performance (because nobody is interested in looking at actual performance). As a result, I'd expect productivity growth to slow.

Guess what? Productivity growth has been slowing.

tanderson923• 10 years ago

I doubt that the world economic slow growth projections are due to the 36% of equity and bond assets which are indexed instead of actively managed.

If that were true, then the 64% of actively managed funds would have a clear opportunity to capitalize on this fact for higher returns.

xyience• 10 years ago

Perhaps overly generalizing, most everyone's portfolio is a poor approximation of the overall market with extra fees taking away even more -- hence the index funds tracking the overall market (or just the traditional top companies like S&P 500) will generally do better. When the market goes tits up, pretty much everyone will take a hit at the same time, index-fund holders and people with more specific portfolios alike. The people that won't be hit hard will be those with more "safe" investments (that don't outpace inflation...) like bonds, those who saw it coming and invested in negative-indexes, or those who get lucky with e.g. penny stocks / startups.

dragonwriter6• 10 years ago

What is the risk when a large percentage of the middle class and others are all in low fee index funds?

One risk is that index funds aren't really unmanaged, they are managed by people who set and apply rules as to what is included in the index. The greater proportion of total investment that is passively (i.e., without deep research into the practices behind the index) invested in such funds (and, particularly, the proportion that is passively invested in any one such fund), the greater the risk of the rules and practices of setting the index being manipulated.

erikb• 10 years ago

I think you are already on the right track. In the end it's always hard to predict how something will turn bad. But you can already tell that a monoculture of simplicity will turn bad at some point. That's already enough to make a judgement call.

iofj4• 10 years ago

There's a number of risks associated with ETFs that isn't associated (or less) with individual stocks.

As a rule of thumb you might assume that if the index goes down, the index fund will add 1-5% going down (large index funds only), and if the index goes up, the index fund will "lose" 0.1-0.5% of that value going up. ETFs are similar. Why ? Lots of reasons:

1) gating (during periods of heavy activity, the adding or removing shares process can block. Additionally, due to new regulation the management of the ETF can impose this without recourse for you. So if the ETF drops 20% in an hour, but you notice this 5% into the drop and want out, chances are good you won't be able to)

2) slippage (due to time delays, contracts, fees, the fact that fractional share ownership doesn't exist, ...) $100 added to an ETF does not result in $100 increase in ETF value. This affects smaller ETFs more than larger ones, but it means that when the S&P 500 goes up 10%, SPY goes up 9.9% or so, when it goes down this makes the drop worse (so, say 10% -> 10.1%). There have been cases where slippage has been large, especially in smaller ETFs).

Note that the reverse is also true, unless you're a billionnair (or at least dozen millionaire). Maintaining "your own", say, SPY equivalent account by owning individual shares will likely cost you more in fees than it would cost you to own the equivalent SPY shares. Additionally if you have less money than the ETF, you'll have to have a rougher approximation.

4) slippage due to add/removes from the S&P 500 index. Since the ETF will have to make suboptimal (very large) trades when the index changes, this will cause the value of the ETF to "slip" compared to the index itself. Putting it separately since it results in bigger amounts.

So the SPY index tracks something between the S&P500 and this list : http://siblisresearch.com/sp-500-additions-removals/

This has, in the past, affected the difference between an S&P 500 index and an ETF more during recessions and that will continue.

5) Global synchronization. Many people use an ETF like SPY as an alternative for a 50% bonds 50% stocks portfolio. Needless to say, this is less diversified, and carries more risk.

6) Generally speaking, an ETF is of course vulnerable to the same risks as the individual stocks, to a lesser extent. However, bad things will happen to the ETF when bad things happen to any large holding. The thing is that the odds go up much faster than I bet people would expect.

Let's say the odds of something really bad (getting economic sanctions, default, bankruptcy, ...) happening to a top-10 S&P 500 company are 1% (happens once every century). We all (should) know the formula that determines risk across SPY as a result of that, but do you know what value it gives for this scenario ?

It's just shy of 10%.

So under these assumptions you can expect a 6-7% drop in the SPY etf every decade that won't be reflected in the index (index can, "for free", just remove failed stocks and replace them, the ETF can't). I hope you agree those are reasonable assumptions.

jerryhuang100• 10 years ago

“Yes, you need to diversify... mix your more established growth names–e.g., your Microsofts, your Intels, your Ciscos, your Yahoos, basically, the reliable blue chip stuff–with higher-risk bets–something like an Astroturf.com, or an Iomega, or a JDS Uniphase, that will offer high-powered upside if things work out for those companies. That will give your portfolio balance, without sacrificing growth."

It's really a joke for this portfolio from some TV gurus from that time around '99, as every "blue chip" companies on the list mostly worth significant lower in '16 from their '99-00 heights: >-50%+ INTC, CSCO, YHOO (not to mentions it's on the selling block). Maybe MSFT is an exception. Those high-risk bets? more like busts: astroturf (?, never heard of it), IOM (from $100 to $3.56 when acq'd by EMC), JDSU (from ~$300 to $6 as VIAV and $25 as LITE). I really do not see what growth in such portfolio.

This just reminds me the moment that Jim Cramer and other pundits on TV urging investors to buy and hold Lehman Brothers stocks before its fall in '08 "because it's too big to fail".

miseg• 10 years ago

Dealing with retirement investment policicies offered in Ireland, I see two sides:

1. Actively managed funds diversified across equitieis, bonds, cash, etc

2. Index funds for specific indices, such as "top 4,000 US companies"

The danger with 2, they say, is you're not diversified. That'll be up to me I suppose to try to diversity into other areas.

baus• 10 years ago

Maybe that is a function of your market, but indexing doesn't prevent you from becoming diversified.

arielweisberg• 10 years ago

Most popular index funds are very diversified. 4000 companies not diversified enough for you? There is research that suggests any 50 companies picked at random will give you quite a bit of diversification.

The real lack of diversity is that it's weighted towards US companies which some people have decided they want and others don't, and apparently it's weighted towards stocks as an asset class as well.

I don't think weighting is the same as lacking diversification, although certainly you are lacking one kind of diversification.

iofj4• 10 years ago

I would think that generally one means different things. Specifically, a diversified portfolio would hold stocks and bonds.

Or, if one is of the "stocks don't go up over the long term" persuasion, it means stocks + shorts (for a net market neutral portfolio) and bonds.

So no, popular index funds are not diversified. There are exceptions, of course.

hrez• 10 years ago

What they mean is that it's all in highly correlated assets. It lacks diversification across non-correlated asset classes. Stocks (US and emergent), bonds and cash are less correlated than US companies even 4000 of them.

nxzero• 10 years ago

Impact is nothing.

Whole point of indexed funds is match the market. If you feel that as an investor you're able to beat the market, which includes indexed funds, good luck.

"Fool and their money are soon parted."

pbreit5• 10 years ago

The distinction between passive and active management is kind of a misnomer anyway, right?

There's no reason an "active" manager can't just select x00 companies by some criteria, publish that list and then just invest in that basket with modest adjustments?

At this point, the primary advantage that "passive" management has is extraordinary marketing, mainly through the selection of S&P 500 components.

known• 10 years ago

Gold gave better returns in last 10 years http://www.nsegold.com/why-invest-in-gold.php

The Impact of Index Investing: A Follow-Up

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