What if everyone indexed stocks?

[Indices]

I see this topic on the Boglehead forum occasionally and I am never satisfied with the answers there, so I'm trying here. I think it is quite possible we will see the vast majority of investors become indexers in the next 30 years, at least in regards to owning stocks. How do you all think this will affect the stock market? At that moment it will be as if the entire stock market is one giant stock, right?

[stone]

I guess it will provide a field day for lucrative price manipulation. If the stock market provides any useful purpose, then that purpose is lost by indexing.

[Tortoise]

The more people index, the more numerous and obvious the opportunities would become to profit from mispriced stocks.

At a certain point, those opportunities would simply be so numerous and so obvious that at least some people would take advantage of them. As a result, those people would generally enjoy far higher returns than the indexing majority.

However, those index-beating returns would attract increasing numbers of speculators until most of the mispriced stocks were once again (more or less) correctly priced.

This balancing act means there will probably always be a mix of indexers and active traders in the stock market. The ratio between the two may shift over time, but there's no way it would ever shift to 100% indexing--unless indexing were mandated by law, which would destroy the stock market by removing its very purpose of conveying price information to the capital markets (as stone mentioned).

[Indices]

Does anyone think that at the point where most investors are indexing we should change our stock allocation in any way? Would it be permissable to stock pick at that point? The more I read, the more I am skeptical about indexing's superiority. The permanent portfolio doesn't really need to be indexed beyond the stock portion anyway. I think asset allocation is the biggest issue, followed by cost.

[moda0306]

Indices,

What are you reading that's convincing you that indexing isn't all it's cracked up to be?

Most managed stock funds I'd say run at least 1% in expense ratio that you have to offset through increased returns.  Not to mention the increased tax inefficiency of the turnover (which I can honestly say I have NO idea how much affect that has).

I guess I've seen little evidence that managed funds as a whole are better, so then you're left with the odd pile of managed funds that DID manage to beat VTI or SPY or something over the past 3, 5 and/or 10 year period, consistently, by over 1%.  If they did manage to pull that off, you still have to hope that 1) it hasn't been priced into the funds NAV by now (even if BRK can pick stocks well, it might be priced into the stock at Time 0 and almost wipe out much of the value by Time 1), and 2) they'll be just as good going forward at picking stocks that beat the market.

No need to give up insider secrets, but if you have some good links to articles on the topic or funds that you think can beat the market over the next 5-10 years I think we're all ears.

[cabronjames]

Any current stats on what portion of stock assets (total dollar value), are managed via a stock index investing approach?

portion of individual investors take this approach?

portion of institutional investors (pension, insurance) take this approach?

The notion of stock index's superiority is not a secret, with iirc stats like only 3% of stock active mutual funds can beat the S&P500 index over 20 years, & then the fund that beats it is unlikely to beat the index in the next x years, such that it seems that the "beating the index skill" is not repeatable.  Unlike a repeatable skill like tennis, where Rafa Nadal would destroy me any year, be it 1995, 2011, or 2040.

Yet it does seem that the majority don't believe this notion.  iirc someone on this board mentioned a significant portion of the FIRE industry jobs, is based on the supposed skill of stock picking, so this group has an interest in ignoring or denigrating stock index investing.

[Indices]

Indices,

What are you reading that's convincing you that indexing isn't all it's cracked up to be?

Most managed stock funds I'd say run at least 1% in expense ratio that you have to offset through increased returns.  Not to mention the increased tax inefficiency of the turnover (which I can honestly say I have NO idea how much affect that has).

I guess I've seen little evidence that managed funds as a whole are better, so then you're left with the odd pile of managed funds that DID manage to beat VTI or SPY or something over the past 3, 5 and/or 10 year period, consistently, by over 1%.  If they did manage to pull that off, you still have to hope that 1) it hasn't been priced into the funds NAV by now (even if BRK can pick stocks well, it might be priced into the stock at Time 0 and almost wipe out much of the value by Time 1), and 2) they'll be just as good going forward at picking stocks that beat the market.

No need to give up insider secrets, but if you have some good links to articles on the topic or funds that you think can beat the market over the next 5-10 years I think we're all ears.

I do not believe in market timing except for the theoretical scenario I've laid out which may never occur in our lifetime. But I feel the enormous growth in indexing in the last few years may only continue until we reach the point where everyone is indexing or in a managed fund that is closet indexing. Look how large Vanguard is now.

Right now I think stock picking is a dead end, but will it be in 20 years? The point is to do what no one else is doing. If everyone is indexing, everyone is using the stock market as one giant stock. What do we do then? I am not advocating anything because I really don't know what to advocate. I am just worried about a potential future scenario.

[stone]

I suppose the amount of money traded through stock index futures is perhaps the bulk of the money acting in an indexed way. Also many supposedly managed funds are closet indexers.

[moda0306]

I think if we could have some sort of statistical layout of indexers vs picker-funds in terms of how much is invested in each to see if there's some sort of point we've reached where over-indexing has made the market too apathetic to value.

That said, are we even to that point?  Just because Bogleheads scream about it, I wouldn't be too confident that we have MORE indexers today as a percentage of the total stock market investment as opposed to picker-funds and individual stock holders than we did in the 1950s or 1960s... didn't everyone index back then (if you can call the DJIA an index)?

[Tortoise]

Any current stats on what portion of stock assets (total dollar value), are managed via a stock index investing approach?

portion of individual investors take this approach?

portion of institutional investors (pension, insurance) take this approach?

According to Figure 2.11 in this Investment Company Institute paper, 14.5% of equity mutual fund total net assets in 2010 were invested in index funds.

For what it's worth, John Bogle gave this lecture back in 2004 in which he said index funds made up "one-sixth," or about 17%, of all equity fund assets at that time. He may have used a slightly different methodology than ICI's to come up with his number (or maybe he just had a vested interest in slightly inflating the number).

I haven't seen anything yet that shows the active/passive breakdown for individual vs. institutional investors.

[Indices]

Any current stats on what portion of stock assets (total dollar value), are managed via a stock index investing approach?

portion of individual investors take this approach?

portion of institutional investors (pension, insurance) take this approach?

According to Figure 2.11 in this Investment Company Institute paper, 14.5% of equity mutual fund total net assets in 2010 were invested in index funds.

For what it's worth, John Bogle gave this lecture back in 2004 in which he said index funds made up "one-sixth," or about 17%, of all equity fund assets at that time. He may have used a slightly different methodology than ICI's to come up with his number (or maybe he just had a vested interest in slightly inflating the number).

I haven't seen anything yet that shows the active/passive breakdown for individual vs. institutional investors.

You have to add in closet index funds as well. I believe Bogle said that would double the figure.

[moda0306]

What is a "closet index fund?"

[Indices]

What is a "closet index fund?"

Actively managed funds that simply follow the index and don't stock pick. There's no way to prove they are doing this for sure, but if their performance closely matches a relevent benchmark over a long enough period of time, they probably are. The problem is they will still charge shareholders higher fees. The fund managers have basically given up on trying to beat the index because they know very well that stock picking doesn't work.

[stone]

Indices, I have to admit that I'm very naive about all of this but on the face of it I'd have thought that an equall weight portfolio of stocks should in principle be able to harvest random jitterings that pass by a cap-weighted index. If I was faced with having to manage a stock portfolio, I'd be tempted to just pick what seemed a diversified set of say a dozen good companies and maintain them all at equal weight taking care to ditch any that looked in peril of irreversible collapse. To my mind it doesn't matter that it is impossible to be better at stock picking than the market. The volatility capture that comes from maintaining equal weights is where the gains would come from. I happy to accept that I'm in a stupid muddle but its not clear to me where I'm wrong. I think norm (on here) did an actual did a backtest of such an approach and said it worked. If the rebalancing was against a complete PP my guess is that it might be even better. I've pasted his post below:-

"Without having to modify my program code, I was easily able to make 2 runs.  I used all 14 stocks without anything else (gold or treasuries of any kind) and had data for the past 49 quarters.  For the first I didn't rebalance at all and the second I used 40% bands.  Some interesting results:
$ 10,000 grew to $ 112,304 in a little over 12 years without rebalancing.  With rebalancing it grew to $ 119,243 (a 6% improvement),  but rebalanced 13 times.  I also tried rebalancing with other bands (20%, 30% and 50%) as well as rebalancing once a year.  Using the 40% bands had the best result, although all were fairly close.  It would be easy to determine when an individual stock is above the 40% as it would be above 10% of the total stocks (1.4 x 1/14 works out real nice).  At the low end a stock would have to fall below roughly 4.25% of the total stocks (.6 X 1/14).  Originally I was going to buy 12 stocks at 3K each and have 36 x 4 or $ 144K.  However after I decided to go with only 3 components, I thought 14 stocks at 5K each would be best and now have 3 x 70 or $ 210,000.  1/2 of 1 % means it would grow an additional $ 1,050 a year (my best guess), so you have convinced me it would be worth watching the individual stocks and rebalancing them as necessary.  I am a little concerned with all my modeling and hope it all holds up.  Someone once said the trouble with simulation is that it is a lot like masturbation - if you do it enough you could begin to think it is the real thing.
Norm"

[Tortoise]

What is a "closet index fund?"

Actively managed funds that simply follow the index and don't stock pick. There's no way to prove they are doing this for sure, but if their performance closely matches a relevent benchmark over a long enough period of time, they probably are. The problem is they will still charge shareholders higher fees. The fund managers have basically given up on trying to beat the index because they know very well that stock picking doesn't work.

Or, a fund may have no choice but to become a "closet index fund" simply because it gets too large to engage in profitable active trading. Above a certain size, a fund's trades become so large that they actually cause individual stock prices to "react," which reduces or even eliminates the profitability of the trades.

My understanding is that this size limitation has driven many Wall Street quants to devise clever algorithms intended to "disguise" extremely large buys/sells by breaking them up into a bunch of smaller ones executed at "random" moments over a certain period of time. And I'm sure other quants have devised clever algorithms intended to identify those "disguised" trades and act accordingly. Like a game of cat-and-mouse.

[MachineGhost]

Does anyone think that at the point where most investors are indexing we should change our stock allocation in any way? Would it be permissable to stock pick at that point? The more I read, the more I am skeptical about indexing's superiority. The permanent portfolio doesn't really need to be indexed beyond the stock portion anyway. I think asset allocation is the biggest issue, followed by cost.

Indexing is only superior to incompetent active management (95% of Wall Street).  With indexing, you're gettng an average which implies that theres at least 50% of people getting above average performance.  However, net of fees and all that which shifts the entire return distribution to the left, it is more like only 33% get above average net performance, so 66% are net average to net underperforming.  Being above average is not a lazy "set it and forget it" position to take, it requires constant discipline and diligence.

MG

[shoestring]

It couldn't happen, is my answer.

Indexing is, in my view, derivative of the trading market.  Total indexing = no market = no derivatives of said market.

That said, indexing isn't the completely lazy decision it's made out to be either in my opinion.  First you have to decide which index is the "best" one to follow.  Wileshire 5000, S&P 500, Russell 3000, ETSE Ex-US, etc. etc. there's ten million of them.  By the time you buy into one you're effectively putting your money on one horse to finish in the middle.  It may be a historically very consistent horse whose performance is very close to other horses, but you don't know that going forward.

And on top of that, you have tracking error risk, so you actually are depending on the skill of the manager to track the index's performance.  There is just a little bit of guessing and picking going on at some level I bet, even with fancy computerized models and robots doing most of the trading.  Heck, the fact it's computerized inherently means we're guessing because humans write the algorithms.  The trouble with computers is they do exactly what you tell them to.

I mention this because I used to be in a position to see what some very wealthy people held.  Very wealthy people tend by and large not to index their domestic equities.  Don't ask me why, it's probably because most of them pay someone else to tend their fortunes and their brokers don't make as much money that way.

At any rate, most of these portfolios, if you look at their components, and then look at the top 10 or sometimes as many as 20 to 30 holdings in the Vanguard Total Stock Index fund, had amazing overlap and were roughly proportional to boot.  Others held actively managed funds which held large caps which often looked a lot like index funds too.

The point being, even if only so much is formally held in actual index funds, I wonder if most of the market is not effectively already indexed in rough, broad strokes.

[stone]

Doesn't Bogle call that "closet indexing" and says its as large as the overt, out and proud, index fund market?

I still have a hunch that 10 diverse, decent companies each held and rebalanced at 2.5% of the PP would beat the standard index fund PP.

[dualstow]

Indexing is only superior to incompetent active management (95% of Wall Street).  With indexing, you're gettng an average which implies that theres at least 50% of people getting above average performance.  

50% of people? Or, a few spectacular companies that almost no one (less than 1%) knows to buy before they are part of the index.

The more I read, the more I am skeptical about indexing's superiority.

But, your handle is Indices for the love of God. 

[AgAuMoney]

Don't forget how indices are chosen...  Usually there is a discretionary choice involved somewhere, either in the selection of securities, the weights, or the formula used for either of the above.

Add to that the modern evolution of indices, there are more created every year for the sole purpose of creating a fund that will track the new index, trying to capitalize on the index investing craze with their own little niche.  If the trend continues, perhaps we'll see an "index of companies not included in any major segment index" (probably phrased a bit differently) or an "index of 'recent' IPOs" (for various definitions of recent).  Hey, I can even imagine a "permanent portfolio index" for every major international market.

Index funds are merely the lastest craze and most of them won't last.  Before the fad they were a useful tool and in the future I expect the remaining index funds to still be a useful tool.  20 years ago mutual funds were "the thing."  Today we have 10's of thousands of funds, hundreds or thousands of which are created or dissolved every year.  Some of them are useful tools, and far more of them are index funds because by putting "index" in their name/description they gain appeal.

I'm with the previous poster who said "[everyone indexing] couldn't happen."  The more investors who index, the greater the opportunities in not indexing.

The dividing line isn't binary on/off and it isn't a fixed point.  The boundary of rewards between indexing and stock picking depends on innumerable variables specific to the markets and specific to the individual making the decision.  Barring market violating legal action, we'll never see any huge shift driven by returns, only by popularity.

[MachineGhost]

Doesn't Bogle call that "closet indexing" and says its as large as the overt, out and proud, index fund market?

I still have a hunch that 10 diverse, decent companies each held and rebalanced at 2.5% of the PP would beat the standard index fund PP.

Of course they would, because the beta would be higher.  It would only be superior if they also generated alpha from your stock picking skills.

MG

[stone]

Doesn't Bogle call that "closet indexing" and says its as large as the overt, out and proud, index fund market?

I still have a hunch that 10 diverse, decent companies each held and rebalanced at 2.5% of the PP would beat the standard index fund PP.

Of course they would, because the beta would be higher.  It would only be superior if they also generated alpha from your stock picking skills.

MG

I wasn't thinking about stock picking, rather simply that a stable decent company will have a stockprice that will meander around irrespective of what trend the company is on (it will revert to trend but jitter a lot to either side). The individual stocks have meaningless jitters in stock price that nevertheless constitute major buy low sell high volatility capture opportunities (just as between PP assets). By keeping ten such stocks each at 2.5% of the PP, such meaningless jitters could be harvested. If you look at charts for a bunch of diverse stocks, those jitters look huge. One stock can zig whilst another zags. Let's imagine that say Rio Tinto has increased in price by 40%; Tesco (or ARM or whatever) won't necessarily have done so at all (or vice versa). Those companies could all have very good long term prospects and certainly not be in some sort of death spiral. It is just a meaningless jitter. Rebalancing out of RioTinto into gold, LTT and cash BUT not rebalancing out of Tesco would seem to make perfect sense

[MachineGhost]

I wasn't thinking about stock picking, rather simply that a stable decent company will have a stockprice that will meander around irrespective of what trend the company is on (it will revert to trend but jitter a lot to either side). The individual stocks have meaningless jitters in stock price that nevertheless constitute major buy low sell high volatility capture opportunities (just as between PP assets). By keeping ten such stocks each at 2.5% of the PP, such meaningless jitters could be harvested. If you look at charts for a bunch of diverse stocks, those jitters look huge. One stock can zig whilst another zags. Let's imagine that say Rio Tinto has increased in price by 40%; Tesco (or ARM or whatever) won't necessarily have done so at all (or vice versa). Those companies could all have very good long term prospects and certainly not be in some sort of death spiral. It is just a meaningless jitter. Rebalancing out of RioTinto into gold, LTT and cash BUT not rebalancing out of Tesco would seem to make perfect sense

There's no free lunch.  Highly volatile stocks are not low risk stocks.  Companies with great fundamentals are not volatile (i.e. wide moat, consumer defensive).  I think what you're really catching onto is high beta for the volatility capture.  I understand that is what Browne originally recommended for mutual funds before index funds.  I've always felt that had merit but once you get away from fundamental analysis, you are speculating not investing.  I've yet to see anyone backtest this approach within the PP framework (Clive, you listening?).  But, I think its going to be an extremely hard sell to PPers over fundamental analysis for stock picking.  You wouldn't want to do worse than just any average index with all the junk stocks included.

You should check out the thread where I mentioned the "Upside Potential Ratio".  While its far from the best way to pick stocks, its a good conceptual framework for thinking about it.

MG

[stone]

Machine Ghost, if you chose the  most solid safe companies from each of ten diverse sectors eg the most solid miner, the most solid utility, the most solid insurer, the most solid oil company, the most solid booze maker, the most solid retailer, the most solid computor company, the most solid supermarket, the most solid pharma  company etc etc; then each still has a lot of individual stock volatility and they do not move in lock step. Just look at the charts for a bunch of Dow or FTSE100 stocks. I think making the most of what essentially is random noise might be a free lunch. It requires rebalancing within the context of a PP so as to have plenty of the non-stock assets in order to provide sufficient rebalancing depth.

[MachineGhost]

Machine Ghost, if you chose the  most solid safe companies from each of ten diverse sectors eg the most solid miner, the most solid utility, the most solid insurer, the most solid oil company, the most solid booze maker, the most solid retailer, the most solid computor company, the most solid supermarket, the most solid pharma  company etc etc; then each still has a lot of individual stock volatility and they do not move in lock step. Just look at the charts for a bunch of Dow or FTSE100 stocks. I think making the most of what essentially is random noise might be a free lunch. It requires rebalancing within the context of a PP so as to have plenty of the non-stock assets in order to provide sufficient rebalancing depth.

I'm still skeptical.  Based on my empirical and backtest experience, "Beach Front Property" companies do not have a lot of volatility relative to each other, except maybe in mining, finance and other leveraged industries.  But the Dow or FTSE100 are not "Beach Front Property" stocks, they are "Prom Queens" with all that entails.  Generally, as a rule, the worse the fundamentals, the more volatile the stock is, because volatility is synonmous with default risk.

I think what you want is a combination of high alpha and high beta.  That way you get the edge for investing, but also the volatility for capturing.

MG