One valid reason to hate indexing

[TripleB]

I read this on Fat Wallet Forums on a discussion on Facebook IPO. Several people commented on it being a bad investment and a few people ask how to get it IPO. One person writes:

"Don't worry even if you don't get in on the IPO, your 401k mutual funds and index funds and ETFs will be required to load up on this dog, making you substantially poorer and wall st very much richer. And so the ponzi fleecing game continues."

And there you have it ladies and gentlemen. Why I dislike index investing. I can be of the belief that a stock is horrible, but I have no choice but to own it. One might argue that FB will be less than 1% of my S&P500 index fund, but the point is that everyone who indexes will be forced to buy their stock, thus making the founders of FB rich beyond belief, even though they don't deserve it.

FB might really be worth 1/100 of what they IPO at, but because index funds are required to buy them, it will transfer wealth to the founders/initial investors.

I dream of a day in the future where stock trades are nearly free, and I can pick and choose 1000 stocks to own instead of the 5000 in TSM. Maybe I'll beat the index by 1 or 2% or maybe I'll lose by 1 or 2%. With such large number of stocks, it's unlikely I will do much different. However, I will know that I'm not investing in companies that I despise and believe will fail.

Similarly, I wanted to boycott companies that supported SOPA but I couldn't. Imagine if investors started pouring money out of SOPA-supporting companies? We saw what happened when customers started pulling out of GoDaddy for their SOPA support. What if 10% of investors were ideological and said "fuck you" to Disney and stopped buying their stock as part of the index? Sure, other investors would come in and buy the stock "undervalued" but what if 20% of investors refused to buy it? Eventually the stock price would fall and it wouldn't be "undervalued" but a new low "market value."

I propose that one reason why big corporations are in control of everything today is index investing. I don't have an easy way to say "no" to a big company who is lobbying for legislation that will reduce my civil liberties. The 401k system locks people into using a select set of funds, so they may not even have an option to use a brokerage account.

I believe in 20 years, a system will be devised that, to the chagrin of big companies, people will be investing based on ideological belief in addition to financial fundamentals.

[dualstow]

One might argue that FB will be less than 1% of my S&P500 index fund

It might be 0% of your 500 index fund. I mean, it's not necessarily going to be part of the S&P for a while, is it?
By the time it is, maybe you'll want it.

but the point is that everyone who indexes will be forced to buy their stock, thus making the founders of FB rich beyond belief, even though they don't deserve it.

You shouldn't trouble yourself over that. They're already rich. There are all kinds of people who don't deserve to be rich because they murdered someone and plundered their wealth instead of founding the largest social network site the world has ever known. (Ok, I'm actually not sure about the numbers. Weibo has grown, but Facebook was first). Do I feel good about enriching the bank accounts of executives at Altria or Reynolds American? Not really, but I own shares.

[BearBones]

Got your point, TripleB. And I totally agree. I do not think that the average investor can beat the market by picking companies individually, hence indexing. But it is very difficult for the average investor to do socially conscious investing with low costs and low risk of major market deviation. In buying the S&P or total US market, you are owning Exxon, Phillip Morris, and a whole host of companies that you might not otherwise wish to support.

[TripleB]

In buying the S&P or total US market, you are owning Exxon, Phillip Morris, and a whole host of companies that you might not otherwise wish to support.

Funny. To me, I have no problem with what Exxon or PM does. I have a huge problem with Disney and other SOPA supporters. Global Warming is a sham. Subjugation of civil liberties is real. Companies that promote destruction of constitutional rights to support their bottom line are the lowest of the low.

[Tortoise]

Great points, TripleB.

The cost of stock trades for the little investor has been steadily decreasing over the years, so my guess is that it's a trend that's likely to continue until little investors can invest in their own "custom indexes" at very low cost.

Because of laziness or lack of interest in investing, most people will probably always either (a) buy established indexes or (b) defer to others for active management of their money. But even if, say, 10% or 20% of investors buy their own "custom indexes," it could have a huge influence over global capital allocation as you said.

In theory, index fund shareholders can influence businesses via votes affecting the board of directors. But that mechanism appears not to be working very well. Making it cheaper for investors to "vote with their dollars" by investing in their own custom indexes would be a great improvement in the capital markets.

[craigr]

Many of these large indices have entry requirements. The S&P 600 (small cap index) for instance use to require IPOs not only be listed for a certain period of time (six months???), but also have a certain number of profitable quarters before they would be added.

As for the larger indices, I need to verify the addition requirements, but I suspect they often have similar rules.

IPOs are, for the uninitiated, one of the worst investments to own. The company and investment bankers hold all the cards. They set the date for the offering, set the price, set the shares to be issued, grease the skids with banks by allowing some early access, etc. Never buy IPOs no matter how tempting the media hype says they are.

[craigr]

From Standard and Poor's Eligibility Requirements starting on Pg. 5

S&P U.S. Indices Methodology

Financial Viability. Usually measured as four consecutive quarters of positive as- reported earnings. As-reported earnings are Generally Accepted Accounting Principles (GAAP) net income excluding discontinued operations and extraordinary items. For REITs, financial viability is based on both as-reported earnings and Funds From Operations (FFO). FFO is a measure commonly used in REIT analysis.

Another measure of financial viability is a company’s balance sheet leverage, which should be operationally justifiable in the context of both its industry peers and its business model.

Treatment of IPOs. Initial public offerings should be seasoned for 6 to 12 months before being considered for addition to an index.

So no the index funds are not going to load up on Facebook when they go public.

[dualstow]

This thread also reminds me of when I received a krugerrand as a gift at a very, very young age.
My dad patiently explained to me that there were some bad things going on in South Africa, and...
"It's a gold coin, right? I'll take it!"

Now I'm older and I've learned to feel guilty, but socially responsible investing- that's really hard. Better to just focus on that when you're giving to charity, in my opinion.

[BearBones]

Better to just focus on that when you're giving to charity, in my opinion.

The most profound negative impacts that many of us have on the world are through the market signals generated by our consumption (and ownership, in this example), IMO.  Unless you are creating a Bill and Melinda Gates type foundation, our charitable contributions often do not amount to all that much. Nonetheless, I continue in my consumptive lifestyle, buying indexes, driving my car around and, yes, donating to charities at year end to help forget about it all.

[MachineGhost]

Many of these large indices have entry requirements. The S&P 600 (small cap index) for instance use to require IPOs not only be listed for a certain period of time (six months???), but also have a certain number of profitable quarters before they would be added.

As for the larger indices, I need to verify the addition requirements, but I suspect they often have similar rules.

IPOs are, for the uninitiated, one of the worst investments to own. The company and investment bankers hold all the cards. They set the date for the offering, set the price, set the shares to be issued, grease the skids with banks by allowing some early access, etc. Never buy IPOs no matter how tempting the media hype says they are.

I second that.  IPOs are just a cash out for the owners/insiders or venture capitalists to recoup their investment.

MG

[dualstow]

...
IMO.  Unless you are creating a Bill and Melinda Gates type foundation, our charitable contributions often do not amount to all that much. Nonetheless, I continue in my consumptive lifestyle, buying indexes, driving my car around and, yes, donating to charities at year end to help forget about it all.

Probably true. I continue to take long showers, to eat meat (direct from the farmers, at least) and to buy devices that require rare and exotic metals and minerals to be plundered from developing nations. Also, I don't even think about investing responsibly. There are threads about that here; it's futile. But, to not donate... that's just wrong.  But you're right. It probably has a bigger impact on the donor's own mental well-being than on the intended beneficiary.

[MachineGhost]

Probably true. I continue to take long showers, to eat meat (direct from the farmers, at least) and to buy devices that require rare and exotic metals and minerals to be plundered from developing nations. Also, I don't even think about investing responsibly. There are threads about that here; it's futile. But, to not donate... that's just wrong.  :) But you're right. It probably has a bigger impact on the donor's own mental well-being than on the intended beneficiary.

It really depends on the charity, the size of the charity relative to your donation and how effective the charity is in accomplishing the mission.  I encourage everyone to always use Charity Navigator <http://charitynavigator.org/> and make sure they do not give to charities rated less than 4 stars (max) in both Accountability and Financial.  It is best to treat charities like a portfolio of stocks, you only want to own the best of the best, not the market index.

MG

[dualstow]

It really depends on the charity, the size of the charity relative to your donation and how effective the charity is in accomplishing the mission.  I encourage everyone to always use Charity Navigator <http://charitynavigator.org/> and make sure they do not give to charities rated less than 4 stars (max) in both Accountability and Financial.  It is best to treat charities like a portfolio of stocks, you only want to own the best of the best, not the market index.

I love Charity Navigator, and while I agree with you on maintaining a 4-star portfolio of charities, it's not so easy to own "the best" when it comes to stocks. When an individual charity goes sour, you can give to someone else next year. When you own shares of the stock, not so easy. Harry Browne recommended an index fund (a few of them actually), and that's good enough for me.

[dualstow]

I wonder if anyone is following this thread over at bogleheads.

It begins:

There is an article by Floyd Norris in today's online NYTimes about a Chinese coal mining company which issued fraudulent stocks (if I understood it correctly) which American investors bought. The article mentions that Vanguard bought more than half a million shares in this company (which it sold again at a loss) for one of its funds. I would be very interested to know which of Vanguard's funds this was. Was I an investor in a Chinese company?? The fraud was so blatant that it's amazing to read about.

Edit: I found the nytimes article.