When will indexing blow up?

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I Shrugged
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When will indexing blow up?

Post by I Shrugged »

I get this free market and ramblings email from Jared Dillian, which I enjoy. Today's was about indexing being a time bomb. This is something I have thought for years. When everyone owns the index, it will no longer be a safe thing. I could not find a link so here is the actual text. Thoughts?

Here is a link to get the free email letter: https://www.mauldineconomics.com/the-10th-man
The Indexing Bomb
Jared Dillian

Last week, I spoke at the Mississippi CFA Society’s annual forecasting event. It was one of the most pleasurable events I have attended. Don’t believe the negative hype on Mississippi. It’s an amazing place, and I would live there in a second. I am not kidding.

One of the things we talked about on the panel discussion was indexing. I can’t remember specifics, but I’ve probably talked about indexing in The 10th Man before. It is a bomb. Or more like a slow-moving electromagnetic pulse. Right now, 56% of all stock market assets in the US are passive, up from 50% a few years ago and up from 2% in 1999. In Japan, over 70% of all stock market assets are indexed.

You’ve probably heard a lot of active managers complaining about how hard it is to beat the index these days. It’s difficult to explain the mathematics behind it, even in terms a layman would understand, but just know the more the market is indexed, the harder it gets to beat the index. Which naturally increases the incentive to passively invest.

This is why I call indexing a bomb. Vanguard is a bomb. The more assets Vanguard gets, the more it lowers its fees, which encourages more people to send their money to Vanguard, which results in more money under passive management. It’s a self-reinforcing process that is not going to stop until the entire market is passive. And then what? What will happen next, when everyone owns an S&P 500 index fund? You basically own pure beta, and all the diversification benefits disappear. They have already disappeared.
Volatility

One thing I like to point out to people is this:

When you invest in an index, you get the return of the index, but you also get the volatility of the index.

A lot of people like the returns of the index—you beat active managers over 99% of the time on a 10-year basis, or something like that. But the returns come with volatility. You may be getting the return of the S&P 500, but you are also getting the volatility of the S&P 500. And the S&P 500 is pretty volatile! It moves, on average, a little more than 1% a day, or up to 20% a year. That’s a lot for your retirement savings to move around. Americans don’t think about that much. Stocks go up over time, right? Just dollar-cost average and invest for the long run, and everything will work out.



But over any 40-year investing career, there will be one, two, maybe three 50% drawdowns. And as much as you believe in stocks for the long run, it is difficult to maintain that faith in large drawdowns and in periods of huge volatility. So, good financial advisors will try to mitigate that volatility by investing across sizes, styles, and different asset classes. This is the point that I was trying to make to the Mississippi CFAs. I’m not sure it got across.

I should also point out that at one point in history, the S&P 500 went down 89%. I don’t care who you are—nobody can withstand an 89% drawdown. Of course, the market did come back… 17 years later. Can you wait that long? What if you’re 62 and planning to retire at age 66, but the market goes down 89% in four years? What then? Are you sure you want to have all your assets in the S&P 500?

I deal with these people all the time. Bogleheads. You cannot invest in the stock market for any length of time without considering the behavioral consequences.
It Wasn’t Always This Hard

I’m old enough to remember a time when investing was easy, when complete knucklehead portfolio managers used to sit back and collect fees for shadow indexing. There have been a lot of price pressures in the mutual fund industry, and it is getting harder and harder to compete. I would say that this is better for consumers in the long run—after all, the fees on some of these index funds are a mere four basis points—but all we’ve succeeded in doing is driving people into portfolios with pure undiversifiable market risk.

Remember, in 1999, an S&P 500 index fund did offer diversification benefits. You owned 500 stocks. But when everyone owns the same 500 stocks, there are no diversification benefits. It’s essentially as if all investors were piled into one stock. And the way to make money in a stock when everyone owns it is to buy before everyone else does and sell before everyone else does. In a sense, we’ve turned everyone into market timers, which was not the intention.

There is a lot more to say here, but this is a good place to stop. You probably think your index funds are the safest things you own. Think again.
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Re: When will indexing blow up?

Post by Xan »

Of course, holding 25% in stocks as the PP does helps tremendously with this risk. Does holding a total stock market fund also help?

The GB is more stocks at 40%, but it's half in S&P/TSM and half in SCV. Or would the concern happen for any particular index? The more indexes out there, the less the concern is valid, I would think.
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Re: When will indexing blow up?

Post by snedgar »

There is an inference that holding an S&P 500 index fund is more volatile than holding an actively traded fund but the author provides no data to back this up, whatsoever.
The author addresses volatility of an S&P 500 index fund as though it is the only asset held in a portfolio and says it's really poor.
There is a reference to good financial advisors mitigating volatility with diversification, although he counters this by later implying that in 1999 S&P 500, alone, did provide sufficient diversification.
This is just noise.
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Re: When will indexing blow up?

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Second time today I get to give my side of index investing.

He seemed to spend a lot of time strictly referencing the S&P 500 fund(s). There are far more index universes than that.

As I stated in another topic I was (good) brainwashed by reading William Bernstein's books.

That led me to making investing choices (allocations) over 20 years ago (January 2003).

Since then I have never added or taken anything out from those investments. All new investing has gone into cash type products.

That has led my current investing being about 1/2 - Treasury Money Market and about 1/2 in the following (again all made investments made in them in January 2003):

European Stock Index
Short-Term Investment-Grade
Value Index
Small-Cap Value Index
Real Estate Index
Total Stock Market Index

Yes, all of them were down in 2008 / 2009 and some other years subsequent. But the amounts by which they went down were always mitigated by the large amounts that have been invested in no risk (albeit low return) cash products.

He does not describe any better alternatives and does not even touch investing in individual stocks which I'd guess has far greater volatility than that which he described which takes place in index funds.
Above provided by: Vinny, who always says: "I only regret that I have but one lap to give to my cats." AND "I'm a more-is-more person."
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Re: When will indexing blow up?

Post by I Shrugged »

Understood.

But, there has to be a market share inflection point, when the index funds have no underlying price discovery and things go crazy.
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Re: When will indexing blow up?

Post by snedgar »

I Shrugged wrote: Thu Mar 02, 2023 12:31 pm Understood.

But, there has to be a market share inflection point, when the index funds have no underlying price discovery and things go crazy.
I agree that, in principle, your assertion does make sense, Shrugged.
One metric that I would take really seriously to indicate that such a think is happening would be if actively managed funds start to outpace S&P 500 index funds.
Also, I wouldn't necessarily expect to see this "blow up", but rather smart people would start to leverage better information to generate better returns.
What do you think?
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Re: When will indexing blow up?

Post by vnatale »

I Shrugged wrote: Thu Mar 02, 2023 12:31 pm
Understood.

But, there has to be a market share inflection point, when the index funds have no underlying price discovery and things go crazy.


I meant to add that I needed to do a search of the oldest article I could find that was predicting similar future problems with index investing.

Also, will there ever reach a point wherein the vast majority believe index funding is the way to go? That they cannot outperform a given market sector by either selecting a managed fund or selecting their own stocks?

Finally, what you ask is similar to the question of how long can our government just keep on creating more and more debt. It seems like we may have reached that point years ago but it is still going on with no yet (predicted) severe repercussions.
Above provided by: Vinny, who always says: "I only regret that I have but one lap to give to my cats." AND "I'm a more-is-more person."
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Re: When will indexing blow up?

Post by joypog »

Maudlin has been bearish for the past decade. I should know, it was his newsletter that froze me in place during one of the biggest bull runs in the stock market ever.

I mean, they'll be right...eventually.

It wasn't until I found the HBPP that I felt comfortable putting money back into the market towards with investments tilted towards different risk factors.

And if it all goes to shit, then no amount of market-smarts will beat an arsenal with canned food.
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Re: When will indexing blow up?

Post by boglerdude »

You can read about it for hours on bogleheads. tldr you only need a handful of market makers. Even here many dont hold total market. They make sector and factor bets.

Also of concern are vanguard and blackrock having your voting rights. And what about when the Fed buys stocks like the BOJ does. As a major shareholder, they can force Walmart et al to verify annual vax status etc
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Re: When will indexing blow up?

Post by Kriegsspiel »

boglerdude wrote: Thu Mar 02, 2023 6:22 pm Also of concern are vanguard and blackrock having your voting rights. And what about when the Fed buys stocks like the BOJ does. As a major shareholder, they can force Walmart et al to verify annual vax status etc
I could see a future where people who start companies don't incporporate, just so that they don't have to deal with blatant racism and sexism from index fund providers and their corporate governance flag-its, on top of ESG and other limitations/requirements of a corporation. I just read an article that mentioned how Aldi, in the UK, was able to execute long-term strategies because they were free to, as a private company. Contrast that with all the corporate malfeasance you hear about, and boards removing the founders of the company (ref James O'Keefe being ousted from Project Veritas after the Pfizer story).

On that premise, the founders who are intent on creating the best company for the long haul could tend to remain private, and thus out of the reach of the stock market. Likewise, shitbags and corrupt boards may start to predominate in the stock market, causing malinvestment and/or a decline in the relevance of the stock market.
You there, Ephialtes. May you live forever.
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Re: When will indexing blow up?

Post by Mark Leavy »

Kriegsspiel wrote: Thu Mar 02, 2023 8:11 pm
I could see a future where people who start companies don't incporporate, {etc}
This is quite astute. I like it.

One of the difficulties that would have to be overcome is that of obtaining capital. Investors would need some mechanism to guarantee their equity allocation. That doesn't sound unsolvable. And, of course, self funding is always the preferred option if you can swing it.
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Re: When will indexing blow up?

Post by welderwannabe »

For indexing to fail we have to assume that there won't be a decent slug of people who think they are smarter than others and can make more money by investing in individual stocks. With human nature the way it is, I don't think that will ever happen...and if by some chance it somehow starts to, then there will be significant arbitrage to be had that people will come out of the woodwork trading stocks again.
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Re: When will indexing blow up?

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Mark Leavy wrote: Fri Mar 03, 2023 10:21 am
Kriegsspiel wrote: Thu Mar 02, 2023 8:11 pm
I could see a future where people who start companies don't incporporate, {etc}
This is quite astute. I like it.

One of the difficulties that would have to be overcome is that of obtaining capital. Investors would need some mechanism to guarantee their equity allocation. That doesn't sound unsolvable. And, of course, self funding is always the preferred option if you can swing it.
Yeah the IPO is the big attraction for most start up funders.
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Re: When will indexing blow up?

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boglerdude wrote: Thu Mar 02, 2023 6:22 pm You can read about it for hours on bogleheads. tldr you only need a handful of market makers. Even here many dont hold total market. They make sector and factor bets.


I can see that making sense.

I wonder how hard it would be for some big money to REALLY move some stocks, then. Maybe not a practical concern.
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Re: When will indexing blow up?

Post by whatchamacallit »

Here is this question answered by Burton Malkiel at the beginning of this year:

https://youtu.be/n9sVJQS5TXw?t=2343


The whole video is enjoyable and impressive coming from the 90 year old Burton Malkiel.
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Re: When will indexing blow up?

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whatchamacallit wrote: Sun Mar 05, 2023 12:01 pm Here is this question answered by Burton Malkiel at the beginning of this year:

https://youtu.be/n9sVJQS5TXw?t=2343


The whole video is enjoyable and impressive coming from the 90 year old Burton Malkiel.
That’s great! And thanks for indexing it to the correct spot.
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Re: When will indexing blow up?

Post by Kriegsspiel »

You there, Ephialtes. May you live forever.
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Re: When will indexing blow up?

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The cap weighted index reflect yesterdays best/worst. Buy the index and you weight more into yesterdays winners. Bogle suggested the ultimate being to buy initially in equal weights and hold that forever, let it find its own cap weighting. but that wasn't something that Vanguard could market.

John Mauldin and others have noted similar https://www.mauldineconomics.com/media/ ... 040309.pdf

Buy 50 stocks at $10/trade = $500 one-off cost.
Hold a $1M in a index fund and even with a 0.05% fund fee = $500 each and every year cost. A small percentage, but a modest amount of cash.
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Re: When will indexing blow up?

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seajay wrote: Sat May 20, 2023 8:02 pm The cap weighted index reflect yesterdays best/worst. Buy the index and you weight more into yesterdays winners. Bogle suggested the ultimate being to buy initially in equal weights and hold that forever, let it find its own cap weighting. but that wasn't something that Vanguard could market.

John Mauldin and others have noted similar https://www.mauldineconomics.com/media/ ... 040309.pdf

Buy 50 stocks at $10/trade = $500 one-off cost.
Hold a $1M in a index fund and even with a 0.05% fund fee = $500 each and every year cost. A small percentage, but a modest amount of cash.
I get what you are saying but.....why couldn't Vanguard market something like this (especially at a near-zero ER.....maybe 0.01% or so or even zero or less once income from security lending was counted in; VINIX--the super institutional $50 million plus minimum investment version of their S&P 500 fund--already tends to actually outperform the raw S&P 500 TR by about 0.01 or 0.02% a year anyway thanks to securities lending revenue)?

LEXCX is a mutual fund that does pretty much exactly what you suggested--it bought a bunch of stocks in 1935 and never sold any of them (with the single caveat that if a stock ever cut its dividend completely it was sold and the money from the sale went into the other stocks in the fund in equal amounts). Thanks to mergers, spin-offs, and split-ups it now owns some different companies than it did in 1935--although some of the same old ones from 1935 haven't merged or changed and are still there--but other than the abovementioned "sell if the company eliminates the dividend totally" rule they have never sold a stock in order to rebalance or for any other reason.

Oh, and LEXCX charges a 0.52% expense ratio....surely Vanguard could do better than that!
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Re: When will indexing blow up?

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Re: When will indexing blow up?

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D1984 wrote: Sun May 21, 2023 3:46 am
seajay wrote: Sat May 20, 2023 8:02 pm
The cap weighted index reflect yesterdays best/worst. Buy the index and you weight more into yesterdays winners. Bogle suggested the ultimate being to buy initially in equal weights and hold that forever, let it find its own cap weighting. but that wasn't something that Vanguard could market.

John Mauldin and others have noted similar https://www.mauldineconomics.com/media/ ... 040309.pdf

Buy 50 stocks at $10/trade = $500 one-off cost.
Hold a $1M in a index fund and even with a 0.05% fund fee = $500 each and every year cost. A small percentage, but a modest amount of cash.


I get what you are saying but.....why couldn't Vanguard market something like this (especially at a near-zero ER.....maybe 0.01% or so or even zero or less once income from security lending was counted in; VINIX--the super institutional $50 million plus minimum investment version of their S&P 500 fund--already tends to actually outperform the raw S&P 500 TR by about 0.01 or 0.02% a year anyway thanks to securities lending revenue)?

LEXCX is a mutual fund that does pretty much exactly what you suggested--it bought a bunch of stocks in 1935 and never sold any of them (with the single caveat that if a stock ever cut its dividend completely it was sold and the money from the sale went into the other stocks in the fund in equal amounts). Thanks to mergers, spin-offs, and split-ups it now owns some different companies than it did in 1935--although some of the same old ones from 1935 haven't merged or changed and are still there--but other than the abovementioned "sell if the company eliminates the dividend totally" rule they have never sold a stock in order to rebalance or for any other reason.

Oh, and LEXCX charges a 0.52% expense ratio....surely Vanguard could do better than that!


This article discusses the success of an equal weighted index:

https://www.morningstar.com/funds/beati ... s-own-game

Beating the S&P 500 at Its Own Game

The triumph of the equally weighted index.

John Rekenthaler
May 15, 2023
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Re: When will indexing blow up?

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LEXCX holds a sizeable proportion in Union Pacific, and some Berkshire Hathaway stock. Initial equal weight not rebalanced will tend to end up like that, more average weighting in the stock(s) that did well. Rebalancing has a tendency to reduce the concentration risk, whilst still tending to achieve the same overall total returns.

At the offset equal weightings is reasonable, as you've no idea which will end up as having been the best. Cap weighting in effect adds more capital to the stock(s) that HAD performed the best up to that point in time, and injecting more capital into those, less into others is in effect a prediction that past momentum will persist, often it doesn't.

On a risk adjusted reward basis, rebalanced tends to yield the higher/better result, same reward with less volatility. As a marketing product I guess Vanguard just prefer a one size fits all rather than having to manage thousands of accounts each with different weightings.

The Golden Butterfly/PP run along similar lines. Stock price only, cash and bonds with interest accumulated, gold ... might each reasonably be expected to negate inflation, but individually with some pretty wild volatility. Equal weightings is inclined to smooth down that volatility, same inflation pacing reward, with less portfolio volatility. Over any one time period you might expect to see the sorted worst to best order (left to right) having a bad case left tail, but where the best case right tail compensates and more that worst case. That's just a natural fractal pattern that applies at both the short and long time scale, and across multiples assets (for instance if you divided the Dow 30 into 5 sets of 6 stocks ranked by total returns worst to best, you'd be inclined to see a similar left tail set compensated and more by the right tail set).

Buying the market, cap weighted index, can accommodate all, however many choose to invest. Equal initial weighting with large amounts thrown at it will disproportionately modify the index, add more to smaller caps. Most investors would be better served by initial weightings, but are left to do that for themselves, such as via the PP, GB ...etc.
Bogle figures his static-50 fund would cost 0.15% of assets to run. Alas, his successor as chief executive of the nonprofit Vanguard Group, John Brennan, doesn't plan to offer the product. Creating new portfolios annually (because newcomers would not be allowed into an existing portfolio) would be an administrative headache with each distinct one lacking sufficient economies of scale, Vanguard believes.
https://www.forbes.com/forbes/1999/0614 ... f358a76874
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Re: When will indexing blow up?

Post by vnatale »

More on indexing / equal weighting:

https://www.etf.com/sections/features/h ... ead%20More

Heavy Lift: S&P 500’s Biggest Stocks Carrying the Rest

ETFs to watch as the index’s top 10 equities make up 90% of gains this year.
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Re: When will indexing blow up?

Post by boglerdude »

S&P isnt the market, they apply a quality screen

Arnott claims any random bag of stocks does better than cap weight
https://www.morningstar.com/articles/61 ... smart-beta

Whats the narrative tho, if YOU can outperform how exactly is the market being stupid about the stock prices. What mistake are the other investors consistently making
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Re: When will indexing blow up?

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OP you may find the concept of the Grossman-Stiglitz paradox to be relevant here.

https://en.wikipedia.org/wiki/Grossman-Stiglitz_Paradox

Essentially, the idea is that there is an equilibrium point where "peak indexing" occurs when the marginal cost of gathering new information and acting upon it equals marginal benefit. Under this model, indexing would never consume the entire market because it would be too profitable to arbitrage informational opportunities.
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