
Are Index Funds Eating the World? - petethomas
http://blogs.wsj.com/moneybeat/2016/08/26/are-index-funds-eating-the-world/
======
Analemma_
As always when articles like this come up, I want to issue the usual reminder
to HN to beware of what pg called "submarine stories"
([http://paulgraham.com/submarine.html](http://paulgraham.com/submarine.html)).
There are a lot of people who stand to lose a _lot_ of money in fees if "just
park it in index funds" becomes more popular advice than it is already. Not to
say the analysis above is wrong, but just keep in mind (especially at the WSJ)
that it may not be coming from sources with your best interest in mind.

~~~
henrikschroder
"A report this past week from investment firm Sanford C. Bernstein, titled
“The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism,”
warned that..."

It would be funny if it wasn't so incredibly blatant.

~~~
mathattack
A friend worked there as an investment advisor and wound up quitting because
so many of their funds were losing to the market.

~~~
partiallypro
Funny enough, index funds outperform hedge funds, etc, however you can
outperform the indices by buying stock at 3:00-3:30pm and selling at 4:00pm
every day, because that's when many funds vest, and when most of the daily
volume occurs. It's a horrible irony. The "3:30 Ramp" is so well known that
there's a Twitter parody account followed by huge swaths of "Finance Twitter."

~~~
dsacco
_> > Funny enough, index funds outperform hedge funds, etc_

I'm weary of reading this on Hacker News. Index funds do not beat hedge funds.
That statement is devoid of nuance and accuracy, and contributes to a
narrative that active managers do not have a skillset or function.

 _Most_ hedge funds do not maintain performance that beats the market, but
_many_ do. This is easily verifiable.

~~~
fauigerzigerk
_> Most hedge funds do not maintain performance that beats the market, but
many do. This is easily verifiable._

Yes, it's easily verifiable. It's also completely meaningless without a
rational way to predict which ones will be outperforming in the future.

~~~
dsacco
It's not at all meaningless, because it is rational to use past performance as
a predictor of future performance.

Past performance does not _necessarily_ indicate future performance, and it
should not be the _only_ predictor, but to dismiss a fund's history as
inconsequential to its future is silly.

A fund's prior performance is a useful signal that can be rationally
incorporated into a risk versus reward decision process.

~~~
fauigerzigerk
_> Past performance does not necessarily indicate future performance, and it
should not be the only predictor, but to dismiss a fund's history as
inconsequential to its future is silly._

I'm not dismissing it unconditionally, but I'm not going to believe it unless
I see the data. What's the probability of a fund outperforming given it has
outperformed the year before?

~~~
j1o1h1n
If it has been doing it for three of the last four years, good. If it has been
doing it for five of the last seven years, dodgy. IANACFA

------
ttcbj
When people wonder what would happen if index funds become too popular, I
usually refer them to Warren Buffet's 2005 essay, 'How to minimize investment
returns':

[http://www.mymoneyblog.com/how-to-minimize-investment-
return...](http://www.mymoneyblog.com/how-to-minimize-investment-returns-by-
warren-buffett.html)

It is essentially a thought experiment about what would happen if everyone
switched to one big index fund.

But, it glosses over the issue of individual security pricing and corporate
management, which would become issues in a 100% pure index environment.

Of course, we won't ever get a 100% pure index environment, because the closer
you approach it, the more incentive there is for active managers to exist.

I think what is really happening is that as more people use indexing, the less
talented active managers are driven out of business. A small number of very
talented active managers may eventually find themselves in a highly
competitive market to exploit pricing inefficiencies, and they will end up
incidentally providing management oversight and marginal pricing services to
the indexers. These active managers will probably look more and more like
private equity firms (taking an active hand in management), and less and less
like traditional arms-length traders.

As long as this small number of talented firms isn't allowed to collude with
each other, or self-deal unethically by controlling management, everything
should be fine. In fact, having met some less talented active traders in
person, I suspect that the quality of marginal pricing and managerial
oversight may go _up_ as the number of active managers decreases, and the less
informed and talented among them are eliminated.

~~~
smallnamespace
> As long as this small number of talented firms isn't allowed to collude with
> each other, or self-deal unethically by controlling management

... and I've got a bridge to sell you.

More seriously though, the smaller the number of players, the more likely (and
easy) collusion becomes. Successful cartels always have relatively few
players.

------
cesarbs
One thing I like to point out whenever this kind of discussion comes up, is
that there is no single index. Articles like this always seem to assume that
everyone will buy the same index, namely the S&P 500 or total US market.

But that's not what a lot of index investors do. Indexers enjoy adding tilts
to their portfolios. So some people will buy value funds, others will buy
small cap funds, and yet others will buy small value funds. There are people
who overweight certain sectors, like REITs or utilities. There are those who
invest in international index funds (with all their variations) and those who
don't. So there's a huge number of combinations you can think of when it comes
to indexing.

Now, with people indexing like that, there would still be market liquidity.
Maybe not as much as when there are single stocks being actively traded, but
on any given day there will be people buying into different indexes, selling
shares, or rebalancing.

Valuation would become troublesome though, but at least people would still get
some return from dividends.

~~~
StavrosK
I guess this is a good place to ask: For someone who knows nothing about the
market, what would be a good way to invest their money? From the responses
here, I'm guessing "park them in an index fund", but is there a trustworthy
company I can talk to that will do that?

~~~
cesarbs
Quick answer:

You could do a lot worse than parking it in an index fund, so yeah, that's a
good approach :) If you have a 401(k) or other retirement account, it is quite
common for those to offer an S&P 500 index fund where you could invest your
money. If you want to do it in a taxable brokerage account, you should open an
account with Vanguard and buy their Total Stock Market index fund (VTSMX, or
VTSAX if you have more than $10,000 to invest).

Then stay the course - if the market tanks 50% the day after you put your
money in, don't panic. Wait it out. Your investment horizon here is at the
very least 10 years.

But that's the quick, the-best-time-to-invest-is-tomorrow-so-just-do-it
answer.

There are a number of things you should do if you want to learn more about how
to invest your money in stocks (and maybe bonds):

0) A good resource to get started quickly is If You Can, by William Bernstein:

[https://smile.amazon.com/If-You-Can-Millennials-Slowly-
ebook...](https://smile.amazon.com/If-You-Can-Millennials-Slowly-
ebook/dp/B00JCC5JKI/ref=tmm_kin_swatch_0?_encoding=UTF8&qid=1472318151&sr=8-3)

But you can skip it if you want to dive deeper with the stuff that follows.

1) Learn about what investing in the stock market means, what's the nature of
it and what to expect from it. I have two recommendations here:

1.1) jlcollinsnh's Stock Series: [http://jlcollinsnh.com/stock-
series/](http://jlcollinsnh.com/stock-series/) He recently released a book
(The Simple Path to Wealth) which is supposedly a better-edited version of the
Stock Series. He's a rather optimistic guy, but what he says is not wrong. He
stays away from investing in non-US markets, which is not the most common
position among indexers.

1.2) A Random Walk Down Wall Street, by Burton Malkiel. It's an amazing book
that everyone should read if they want to learn about the stock market. Many
people recommend Bogle's books (he's the father of index investing), but I
find them incredibly tedious to read.

2) Learn about the different investment accounts available to you -
401(k)/403(b)/457(b)s, IRAs, HSAs, taxable brokerage accounts. Each one
receives different tax treatment and you should be familiar with that in order
to avoid "tax drag" i.e. taxes slowing down the growth of your investments.

3) Another resource I highly recommend is the Bogleheads wiki:
[https://www.bogleheads.org/wiki/Main_Page](https://www.bogleheads.org/wiki/Main_Page).
In particular, check out the following pages:

[https://www.bogleheads.org/wiki/Bogleheads%C2%AE_investing_s...](https://www.bogleheads.org/wiki/Bogleheads%C2%AE_investing_start-
up_kit)

[https://www.bogleheads.org/wiki/Three-
fund_portfolio](https://www.bogleheads.org/wiki/Three-fund_portfolio)

[https://www.bogleheads.org/wiki/Tax-
efficient_fund_placement](https://www.bogleheads.org/wiki/Tax-
efficient_fund_placement)

4) Don't obsess about it once you get started. After you've learned a few
things it's tempting to start "tweaking" your investments here and there, but
if you do that often you do yourself more harm than good. Invest your money
then go have some fun :)

~~~
StavrosK
Thank you for the detailed answer!

------
Animats
From the article: "Funds run by Vanguard hold roughly 6% of total U.S. stock-
market value."

So index funds are not eating the world.

Most Wall Street traders underperform the market. Even the hedge fund crowd
mostly underperforms the market. "A Random Walk Down Wall Street" is real.

~~~
gnaritas
> "A Random Walk Down Wall Street" is real. reply

It's a real book, but it doesn't prove the market is random, nothing does as
the efficient market hypothesis is just that, an unproven hypothesis lacking
even enough evidence to become a working theory.

That certain funds consistently beat the market year in and year out for
decades is enough to disprove the notion that markets are random; they're not.

~~~
drjesusphd
That doesn't prove a damn thing.

When so many people are playing, there's bound to be some that consistently
win, just by chance alone. The book discusses this.

~~~
tcoppi
And there are statistics tests one can use to determine if one's performance
meets those statistical parameters to be random. Many funds and managers beat
it over the long term, such as Warren Buffet, but the vast majority indeed do
not.

~~~
refurb
Warren Buffet usually invests to the extent that he has the power to change
how the company is run. He usually uses that power.

~~~
tcoppi
Does that change my thesis at all?

~~~
refurb
I was just drawing the distinction between beating the market through passive
investing (simple stock picking) vs. what Warren Buffet does.

------
kldaace
"Yet Mr. Fraser-Jenkins has a point. Index funds don’t set prices; they only
accept the prices that active investors have already set. If everyone owned
index funds, he says, “no one would be doing” the job of figuring out what
securities are worth."

The situation described is clearly not a Nash equilibrium. If you have
special, accurate information on the price of a security, then you're going to
act on it. Why would no one be doing the work of pricing something if it's
profitable? Sounds like actively managed mutual funds are getting antsy
because people are starting to realize that they're getting screwed not going
with index funds.

~~~
logfromblammo
If everyone invested exclusively in index funds, and no one works to establish
a market price for each individual component, the obvious thing to do would be
to adjust indices to manage the portfolio based upon actual dividends.

All companies converge on the same P/E ratio, and the ratio of the index
depends on how much investor money is chasing the overall productive activity
of every [investable] company in the economy.

It wouldn't be the end of the world, by far.

But it is doubtful this will ever get even close to happening, because some
investors will always be gamblers at heart, and if they learn that Coca-Cola
is releasing a new beverage flavor, they will use the financial markets to
make bets on whether it will be insanely popular or a colossal failure.

~~~
DennisP
If one company's earnings are growing quickly, and another's is slowly
shrinking, and they have the same P/E ratio, I'm likely to skip the index and
buy the high-growth company directly.

If a company can reinvest earnings at a high rate of return, it's to the
advantage of stockholders if it doesn't pay dividends. How much should the
index weight it?

~~~
logfromblammo
...illustrating why the price system will always be available to value things.

If there is no market trade price for a stock, the only way investors can
realize value from owning shares is through dividends. Increasing the value of
the company does nothing for the owners individually if shares for a specific
company have no individually identifiable price. _Everybody_ is buying and
selling through the automated index funds, remember? The only way to get
higher capitalization in the opinion of the fund robots is to issue better
dividends. There's no one to sell to at a higher price, except the other
robots, who all have similar valuation algorithms, and will need to sell the
same amount as your fund robot in order to realize any gains.

But that is all absurd and moot, because there will always be a price, as long
as two individuals are willing to move differently from the herd. As we are
mostly humans in our market, that behavior is practically guaranteed. The
outlier who thinks the stock is outperforming the whole market will buy from
the outlier who thinks that the stock is underperforming. And their combined
beliefs and opinions will create a price for it.

Ergo, index funds are not eating the world.

The fewer people there are that are willing to try to beat the funds or game
their algorithms, the easier it will be for any one of them to succeed. So
there will always be at least one.

~~~
DennisP
Which makes me wonder whether there's a strategy that specifically takes
advantage of mispricing by overuse of index funds.

First that comes to mind: small caps historically get better returns, and
maybe that difference will be amplified by market-cap-weighted funds.

Picking stocks which are growing but not quite big enough to get into larger
cap indexes could be another possibility.

~~~
logfromblammo
An economist and a reporter were walking down the street when a $20 bill blows
into their path on the sidewalk. The economist looks at it, smiles knowingly,
then steps over it and continues walking. The reporter says, "Why didn't you
pick up that $20 bill?" The economist replies, "If it was really a $20 bill,
someone would have picked it up already."

By the economist's reasoning, someone already has a strategy to take advantage
of index funds. Actually, a lot of someones already have _every possible
strategy_ to take advantage of index funds. So none of them really make
significant returns, because the dead whale is eaten by a million scuttling
isopods, each taking one or two bites before it's all gone. So the real money
is in taking advantage of _those_ guys, perhaps with fees or paid reports or
little boxes that light up and go "ping".

Of course, just because all the free money is already being picked up, doesn't
mean you will never catch a flying $20 bill if you decide to make a grab for
it. No market is perfect, and there's always an opportunity to grab some free
money _somewhere_.

~~~
DennisP
Yep I read Random Walk on Wall Street too, a while back. More recently I read
a stack of books on quantitative investing strategies, which referenced a lot
of academic work. Turns out quite a few academics don't really believe in the
EMH anymore; it's just not holding up to historical evidence. There are all
sorts of factors that can make markets less efficient.

------
turc1656
FULL DISCLOSURE up front - I work in the index/ETF business. I help maintain
~75 indices, many of which have ETFs linked directly to them.

That being said, I fully believe there will always be active investors. As
others have mentioned, if there is an opportunity to make money in the market
due to something like passive index funds being slower on the uptake, it will
be made.

If I had to interpret the core argument being made here, it is basically that
there is a fear of a positive feedback type scenario where money keeps getting
dumped into companies simply because it always has. But it can be highly
profitable to beat out the slow, passive money by doing your due diligence.
For this reason, active management will always exist.

Also, I am fortunate enough to work on some of the more complex and
interesting products in the industry (at least I believe so, haha). I can tell
you that there are definitely sanity checks put in place for this kind of
scenario. Most of it revolves around fundamental ratios built into these
product methodologies (i.e. P/E ratio must be within a rational range, company
must produce stable income for the past 5 years, etc.). More importantly,
securities in these portfolios are frequently weighted (at least in part) upon
those fundamental ratios. So if a company starts to deteriorate, the size of
the position in the fund will be decreased. Much of what the article talks
about seems to be negated by this and becomes a non-issue. I think those
arguments would apply more to benchmark products which don't have those kinds
of requirements. Then again, many benchmarks are used for exactly that -
benchmarking - and aren't directly invested in. There are, of course, indices
like the S&P 500 that have significant sums of money attached to them, but
they are the exception, not the rule. Most index products deemed "investment-
grade" are STRATEGY based, not benchmark based.

Basically, there is room in the market for both. I think we are simply seeing
the progression towards a new equilibrium, nothing more. That equilibrium is
where the new balance of those willing to take a higher risk meet those that
want the less risky, low cost products that we provide. There is simply a much
smaller portion of the population willing to pay higher fees and have a larger
risk (but with possibly greater reward). And that is due in part to the fact
that many money managers don't have the returns to keep people coming back.
It's also due in part to people's mistrust of the market (and financial
industry in general). They are simply allocating their money in accordance
with their risk appetite.

~~~
hulahoof
This comment greatly improved my understanding thanks

------
empath75
Doesn't it seem self-limiting? At some point, if prices become totally
irrational, wouldn't active investors profit by taking advantage of
predictable index fund transactions?

~~~
bbayles
This is an under-appreciated point... if 99 people leave money on the table,
and the 100th person picks it up, we're back to efficiency in the aggregate.

------
twblalock
There will always be active investors. People will always think they know a
way to succeed in the market that nobody else does. It's human nature. Plus,
there will always be VCs, hedge funds, and other high-risk, high-reward
investment vehicles used by the wealthy to add some spice to their otherwise
conservative portfolios.

There may be fewer active investors than before, but that doesn't mean the
market won't function.

------
nabla9
>warned that index funds might grow to the point at which new investments
could be massively mispriced.

This situation will be easy to spot from indicators like P/E ratio. P/E
limited index funds will be new hotness and active investors should get better
returns.

There is bigger problem than index funds and it's closet indexing. Many
portfolio managers that claim to be active investors secretly follow their
benchmark index without exactly replicating it. This is fraudulent behavior.

~~~
jpetso
> There is bigger problem than index funds and it's closet indexing. Many
> portfolio managers that claim to be active investors secretly follow their
> benchmark index without exactly replicating it. This is fraudulent behavior.

As long as they can also provide competitive maintenance fees and tracking
errors don't play against them, I don't see much of a problem. If they
consitently do worse than the ETFs based on the same indexes with a similar
risk profile, the market will eventually punish them for under-delivering.

If they only make a few picks that end up doing well, keeping the rest of the
benchmark for a balanced risk profile seems sensible to me.

Please explain where the problem lies exactly?

~~~
nabla9
>If they consitently do worse than the ETFs based on the same indexes with a
similar risk profile, the market will eventually punish them for under-
delivering.

The problem is with consistency and eventually. Definition of closet indexing
is active share below 60%. These funds are not consistently worse if the
observed period is just few years.

Since actively-managed funds usually perform worse than index funds in long
term, closet indexing should be able to keep up with actively managed fund
with same costs.

Selling funds is mostly marketing. Asset management firms have several funds
and they sell the one that randomly performs better than it's benchmark in
some short period of time (1-3 years). Very badly performing funds are merged
into other funds and new funds are created.

Research shows that 15-20% of European large-cap funds could be labeled as
closet indexers and 15% of the net assets in equity mutual funds sold in the
United States are closet indexers.

------
ergest
This article incorrectly assumes that smart investors would sit around and do
nothing if most people invest in index funds.

------
tedmiston
> If businesses are to be able to raise capital by selling shares to
> outsiders, “you need a deep market of active investors willing to take a
> view on the valuation of the company,” Inigo Fraser-Jenkins, head of
> quantitative strategy at Bernstein in London and lead author of the “Worse
> than Marxism” report, told me this week.

And that's a terrible investment strategy to ask of the average layman, the
people who are concentrating on index investing.

------
ceejayoz
> Because corporations know that, says Prof. Heemskerk, coziness and
> complacency may arise. “If you have only long-term investors, how do you
> keep management on their toes?”

We've a ways to go before the pendulum has swung enough in that direction. I'm
more concerned about the tendency to seek short-term profits at the expensive
of long-term investment in today's Wall Street CEOs.

------
BjoernKW
> But, he adds, that would require indexing to grow immensely from today’s
> levels. Probably not until passive funds are at least 90% of the market
> could such chaos arise, he argues.

That's a pretty hypothetical scenario, isn't it? Index funds, ETFs in
particular, are a brilliant idea that allows ordinary people to participate in
the success of market trailblazers.

If it wasn't for index funds most people wouldn't be able to make reasonable
investment decisions because they're not investment bankers who deal with that
sort of business on a daily basis. Even investment bankers fail with their
investments most of the time. It's usually just the few successful investments
or things like arbitrage that balance out the odds.

Ordinary people usually neither have the knowledge nor the resources to do
investments this way, so index funds probably are the best option for
accumulating wealth over a period of time.

------
ramblenode
> A report this past week from investment firm Sanford C. Bernstein, titled
> “The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism,”
> warned that index funds might grow to the point at which new investments
> could be massively mispriced.

In which case the actively managed funds which identify the mispriced assets
would start making money and attract investors again. You know there's trouble
brewing in the industry when mutual funds are trying to sell investors on
"it's good for the economy!"

------
tedmiston
> That’s largely because index funds trade so much less often than active
> managers. On a typical day, only 5% to 10% of total trading volume comes
> from index funds, says a Vanguard spokesman.

I'm surprised the author omitted it, but can anyone comment whether this is
different for robo investors (Wealthfront, Betterment) vs a traditional index
fund like Vanguard?

~~~
Spooky23
Robo advisors are like meta index funds.

They give you the canned advice that your local Financial advisor gives you,
minus the quarterly meeting and phone therapy when the market goes down, and
plus some automated intelligent handling of capital gains to reduce your tax
exposure.

------
davidgerard
“The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism”

good Lord

------
gersh
Can high-frequency traders replace active investors in an ideal world.
Ideally, the price should be the best estimate of the value of the company
based on all publicly available information. When new information is released,
high frequency traders should rush to profit from the discrepancy. Further,
they can market make based off their knowledge of the stock's true value.
However, this business should face increasing competition until it becomes a
low-margin business. I don't see any inherent reason, active investing should
be super profitable. In the end, it is just another business like any other.

------
lazyevaluate
Besides the issue of corporate ownership / concentration, index funds are also
increasing the risk of a market crash. One of the selling points for index
funds is that they supposedly offer great diversification and this might be
true in normal times but in a financial panic people will pull out of index
funds and drive correlations to 1. E.g. if there's a crash in health care,
panicked investors won't just be pulling out of health care they'll be pulling
out of the market as a whole.

~~~
toennisforst
Yes, but this does not diminish the value of the companies in the long term.
Remember that index funds are an investment vehicle for decades, not months.

~~~
taurath
Only if enough people stick with the long term. If everyone tries to hop off
the boat for the short term, it can be a self fulfilling prophecy that growth
will slow for a decade or more as the market hit effects real business
returns.

------
csandstedt
This is probably the best article ever written about the efficient market
theory and passive investing. It was written by Warren Buffett in 1984.
[http://www8.gsb.columbia.edu/rtfiles/cbs/hermes/Buffett1984....](http://www8.gsb.columbia.edu/rtfiles/cbs/hermes/Buffett1984.pdf)

------
BlickSilly
Not an expert but seeing the quick rise in popularity in anything makes me
nervous. eg. Index funds and ETFs. When Apple is the Number 1 holding of all
index funds, and investors are blindly driving up aapl stock becuase they
continue to want 'index' funds.. how do we protect ourselves and our economy
from a major reset/correction?

------
pbreit
Is it accurate to say that the difference between index and non-index funds is
that a) index funds don't trade as much and b) index funds publish their
components?

Is there any reason an "active" manager cannot behave like a passive manager?
Is index investing just outsourcing the stock picking?

------
bendbro
So people won't be able to make money selling their stocks to other people.
Maybe corporations will simply adapt and provide dividends that appropriately
compensate for the price of the stock?

------
phamilton
Isn't the answer an index of hedge funds?

------
blazespin
Not a big deal. As Index funds trade more, than more opportunity for traders.
It'll balance itself out.

------
princetontiger
Active investing serves a valuable purpose.

10 years ago, everyone wanted to be in the hedge fund industry. Today, it's
tech startups. Having worked in both fields, you encounter the same folks
running from funds to startups.

Hedge fund fees probably move to 1 and 10 over the coming decade, but active
investing and price discovery are very valuable. For those willing to do the
work, small and midcaps still can generate alpha. However, it will require
spending many hours traveling and meeting with management and being engaged in
the sector virtually nonstop (trade shows, conferences, reading
articles/news).

I think generalist active investing will go away, but sector focused active
investing will remain.

------
cloudjacker
"warned that index funds might grow to the point at which new investments
could be massively mispriced"

Could, he says. lol.

------
alaaibrahim
no

\-- Betteridge's law

~~~
Eerie
Is Betteridge's law of headlines always correct? Click here to find out!

~~~
paulddraper
It's 99% correct. If something sensational were substantively true, it would
be stated, not asked.

------
joncp
When a headline is a question the answer is almost always no. This is no
exception.

------
drauh
From the article: A report this past week from investment firm Sanford C.
Bernstein, titled “The Silent Road to Serfdom: Why Passive Investing Is Worse
than Marxism,”

"serfdom", "Marxism"... Let me guess: Libertarian Party propagandist.

~~~
twblalock
> Let me guess: Libertarian Party propagandist.

Or just someone who is well-read and likes to throw in literary references.

~~~
0xCMP
> > Let me guess: Libertarian Party propagandist.

> Or just someone who is well-read and likes to throw in literary references.

~libertarian here: don't know him, but I'd bet he is what op thinks

