
The Growing Peril of Index Funds: Too Much Tech - clorenzo
https://www.wsj.com/articles/the-growing-peril-of-index-funds-too-much-tech-1514457003
======
avar
The second edition of Jack Bogle's "Little Book of Common Sense Investing"
came out this last October. It goes into detail in evaluating active
investment such as what's being recommended in this article v.s. passive
investment.

Plainly put, I've yet to see any compelling evidence that the supposed experts
being quoted in this article can time the market as they're suggesting with
their suggestion of getting out of tech stocks now.

The percentage of active management firms that can beat the index funds even
before you factor in their high fees is so miniscule that random chance could
account for those low numbers.

The market's almost definitely heading for a bit of a crash in a few years,
but it's instructive to look at how passive v.s. active investing did in 2008
(detailed in this book) to see how much these supposed experts really know.

~~~
dbecker
This article is talking about diversification to reduce risk, which is
unrelated to "timing the market" and which can be consistent with passive
investing.

~~~
avar
Some investors described in the article moved from market cap weighted indexes
to ones that were disproportionately weighted to disfavor tech stocks, they
believe that they're overvalued and that they can get out earlier than
everyone else.

That's trying to time the market.

The firms mentioned in the article will be happy to charge you much higher
fees than Vanguard for questionable longer term returns. It's basically a PR
piece for managed investment.

~~~
whack
Even if the average returns and risk are identical for each security
individually, you can minimise your portfolio risk by investing equally across
many different industries. If a downturn were to occur, different securities
in a single industry will be much more correlated, as compared to different
securities across different industries.

~~~
avar
Yes, that makes sense. But that's entirely unrelated to what I'm pointing out
here.

(Some of) the article is making the argument that investors should decide for
themselves how over- or undervalued certain segments of the economy are.

So on one hand you'd have a diverse market cap weighted index where you buy
into stocks representing the proportional to their portion of the economy.

On the other hand you might think you have special knowledge to layer on top
of that. Are banks undervalued? By how much? Let's say 10%. Then let's sell
something else to buy 10% more banks, now what's 10% overvalued? Tech?

I've yet to see any sort of compelling data that this sort of managed
investing is a good idea, and that's what it is.

Just because you're not buying TSLA and instead just disproportionately buying
"car stuff", or not selling AAPL but just selling "tech stuff" you're still
trying to pick stocks and trying to beat other stockpickers doing the same
thing. You're just picking subsets of the economy instead of individual
stocks.

~~~
perl4ever
I don't think it's a good idea to guess what's over/undervalued. But equal
weighting different industries is not quite the same thing. No matter how you
weight things (by capitalization, by company, by industry, whatever) you are
making assumptions about correlations. No dogma can tell you which is right a
priori, because correlations change, especially in crises when it matters
most.

Also...the total market, cap weighted, may be the optimal way to invest the
whole world's capital - but that doesn't mean that it's the optimal way to
invest, say, $50K. If you have $100B, say, you _can 't_ put it in a stock
that's currently valued at $1B. But if you have $1000, you don't have that
constraint.

Regardless of _how_ the optimal portfolio may differ, when you're investing a
relatively minute amount compared to the entire market, it's hard to imagine
the optimum is not going to be different.

...You don't pilot your car under all the same constraints as an 18-wheeler,
just because that's optimum for shipping large quantities.

~~~
pedrocr
>If you have $100B, say, you can't put it in a stock that's currently valued
at $1B. But if you have $1000, you don't have that constraint.

Your argument is that there is a mispriced security somewhere that can be
bought at a low price. There is currently only 1B$ of it available and so the
professional manager with 100B$ to spend just doesn't bother to pick up that
money. But you with just 1000$ can do it instead. What makes the professional
manager pass up on that opportunity? He has at least as much money as you, why
doesn't he invest at least that amount?

In reality that opportunity doesn't exist. Companies can't be consistently
mispriced lower because there is too much demand for their stock. That's not
how markets work for anything.

~~~
perl4ever
Every cap weighted fund has a cutoff where it omits companies that are too
small. But even the stocks that are barely large enough to include don't
contribute much to returns.

I don't think the small cap stock is "mispriced". Rather, it has a different
value for different investors, and the market price is a compromise. That
means different investors should probably have a different amount of it in a
portfolio.

It's an abuse of theory to claim that since the market is efficient, you
should ignore the things that make you different from the total market. For
example, suppose you invest in tax-exempt investments when you are in a low
tax bracket, or even when you are investing in a tax free account. Is that
optimal because markets are efficient? Of course not. Because the value set by
the market does not take into account the way in which you differ.

The reason to believe in index investing is because you understand your own
lack of knowledge and are honest about it. That's a good thing, but it doesn't
justify pretending you don't know things that you _do_ know. People seem to
have the same issue with probability, I find.

~~~
avar
I think you're arguing a point that isn't even being brought up in this thread
or in the article.

Of course it's just fine to have an index fund that's weighted towards certain
types of stock, e.g. there's the S&P 500, then various "woldwide" funds, EU-
weighted funds etc. The risks & benefits of those are well understood. Nobody
argues that different types of index funds shouldn't exist.

Similarly, there's funds that cater to specific regulations, e.g. investing
heavily in "green" stocks which may be subsidized by the government, or
avoiding certain taxes (e.g. lower turnover for lower capital gains).

Both of those are categorically different from supposing that you know better
than other people that tech stock in 2017 is overvalued, and trying to move
away from that in favor of something else. Now you're making an active
investment move which history shows you're more likely to lose on as gain
anything on.

------
brndnmtthws
This is an inherent property of all market cap weighted indexes. An
alternative approach is equal weighted indexes, which have historically
outperformed market cap weighted indexes. There's no free lunch though: this
is a case of your typical risk/reward tradeoff. Equal weighted funds are more
risky (volatile), but have higher historic returns than market cap weighted
funds.

Some of them feature equal weighting across industry sectors as well as
amongst separate companies. Here's an example of one (also note the high
fees): [https://www.guggenheiminvestments.com/etf/fund/rsp-
guggenhei...](https://www.guggenheiminvestments.com/etf/fund/rsp-guggenheim-
sp-500-equal-weight-etf)

I personally just stick with VTI and VXUS for stocks (excluding my Airbnb &
other startup shares), but I also have about 50% of my net worth in crypto
(and I remain bullish).

~~~
pedrocr
>Equal weighted funds are more risky (volatile), but have higher historic
returns than market cap weighted funds.

But do they outperform after risk adjustment? I doubt it and if not you're
better off just leveraging a bit to your desired level of risk. The point of
passive investing isn't that the trading strategy can be automated, the point
is to say "I want to grab exactly the average return of the market every
year". Trying to do anything else is by definition not achievable by everyone
so why do people think they should be the lucky ones? What specific advantage
does a retail investor bring to merit that?

~~~
perl4ever
I don't think it makes sense to equate risk with volatility. Say I have $1M.
If I buy a cap weighted S&P 500 fund, I have about $40,000 in Apple, because
it's about 4%. If I then switch to an equal weighted S&P 500, that $40K will
be split up between 20 stocks with about $2K each. That is clearly more
diversified with respect to company specific risk. It may or may not be worth
it given increased fees, but you can't just dogmatically say it's equivalent
to cap-weighted plus leverage. It's qualitatively different.

~~~
pedrocr
>you can't just dogmatically say it's equivalent to cap-weighted plus leverage

I'm saying it's _strictly better_ to do cap-weighted plus leverage. That's
what financial theory tells us anyway, that the best portfolio is whatever mix
between risk free cash and the same mix as all the assets in the world.
Deviating from that brings you farther away from the efficiency frontier. Now
for this to hold EMH must hold and we know it's not true in the stronger forms
which was why I was asking for a risk adjusted benchmark.

~~~
perl4ever
I don't think there's a theory that tells you risk is volatility. Isn't that
more of an axiom? And I have the distinct impression it was chosen because it
leads to tractable math. I'm not endorsing a specific alternative definition
of risk, but I was suggesting risk is clearly multidimensional and intimately
related to predicting what will be correlated in the future.

------
notadoc
Well you could always avoid the tech heavy indices, but then you're sort of
actively managing your positions rather than letting it be purely passive.

Theoretically, is not another growing peril of indexing that it removes
incentives for companies to behave well or outperform, since if they're part
of an index their shares will be bought automatically by retirement plans and
investors anyway, irregardless of performance or competency?

And yet another theoretical peril question would be, if everyone is indexing,
it surely must lose it's efficacy because it is no longer efficient, will
indexing then not underperform? I suspect if or when that happens, active
management will regain interest.

Indexing by the masses is a fairly new trend, it will be interesting to see
how the markets handle the behavior long term.

~~~
brndnmtthws
This is not quite correct. There are other weighting methods (specifically,
equal weighting) which would prevent this situation, whilst still remaining
passive.

~~~
pedrocr
I'd argue an equal weighted index is no longer passive. You're actively making
a bet that smaller companies will outperform bigger companies. Someone else
will be taking the other side of that bet. Me with my cap weighted index will
get the average of the two and be actually passive.

~~~
perl4ever
But many investors are going to take the side of big companies, not because
they are choosing the optimal approach, but because they _have_ to, because
they have too much capital to invest in small companies. So it's not logical
to assume their returns must be equal on average.

~~~
pedrocr
I didn't say their returns would be equal, I said my returns will always be
equal to the average of the market exactly because I'm a passive investor. The
sum of all bets is what I'll be making. The standard text on that:

[https://web.stanford.edu/~wfsharpe/art/active/active.htm](https://web.stanford.edu/~wfsharpe/art/active/active.htm)

As for there not being enough of the small companies available to do the equal
weighted S&P500, the smallest companies in the index have 3.5B$ in market cap.
So there's almost 2T$ of that mix available and there would be much more if
that amount of capital suddenly decided to implement that strategy as the
market caps of the bottom of the S&P500 index would certainly rise
significantly.

------
JoshTko
"Tech" in this case is an overly broad classification. Apple, Amazon, and
Facebook are all very different businesses and should not have correlated
performance.

~~~
bpicolo
Logistics, hardware, advertising. All very different for sure.

Every successful business has to be “tech” in this century. Tech is how you
achieve high scale

~~~
repsilat
Yeah, if "tech" just means "many employees are programmers" or "has a large
online presence" it seems obvious that tech is going to become a larger
portion of the market, and rebalancing to cut down the "overweight" tech in
your portfolio runs directly counter to what passive cap-weighted investing is
about -- having investments that follow what has won in the past and is
expected to win in the future.

------
zitterbewegung
This looks like a PR piece to make people afraid of investing in the S&P. Some
people have suggested thought that since investing in index funds makes the
companies that are apart of the index fund to not compete with each other due
to their shareholders. I'm not sure if the previous statement is even valid or
real.

~~~
Analemma_
There have a lot of hit jobs on index funds in the last few years, often
published in the Wall Street Journal. Active fund managers are getting really
scared that money continues pouring out of them and into Vanguard as it
becomes common knowledge that actively managed funds almost never beat index
funds net of fees.

[https://news.ycombinator.com/item?id=12368136#12368902](https://news.ycombinator.com/item?id=12368136#12368902)
<\- I said this a year ago and it's going to continue

------
module0000
The growing peril is only for _long positions_. Peril for long positions is
profit for short positions.

Seeing this article advising "reducing your exposure to tech by selling your
tech stocks" assumes that you have no choice to participate other than
_buying_. They are looking at half of the market(buy-side) and ignoring the
equal-sized selling-side of the market. Stocks going down == Short the market.
Stocks going up == long the market. The direction is unimportant, the
volatility is absolutely important - and there is an awful lot of
it(volatility) at the moment.

~~~
astrange
Are you suggesting an index fund that passively shorts everything? I don’t
think that’s in my 401k.

(I use Hedgeable which is the most complex robo-advisor, but as they say they
hedge long instead of using options. Please sign up, I’d be inconvenienced if
they went out of business!)

~~~
module0000
I'm suggesting if the article has any conviction for moving out of tech, then
the smart play is not to move out but to short. The language of "reduce
exposure" is not what you should hear from your advisor/broker. You don't
reduce exposure, you reduce _risk_ by opening short hedges or opening short
outright. If these people are tied up long in QQQ(the article references this
instrument, which is an amateur hour NQ100 ETF), then risk of tech bust is
managed by shorting NQ as a hedge.

------
autokill
[http://archive.is/qPANt](http://archive.is/qPANt)

------
greggarious
Balancing your portfolio with domestic (US) and international index funds
would seem to take care of that since.

I'm currently 60/20/20 US/International/Bonds IIRC.

If the US market is mostly tech and tech bottoms out when I want to retire, I
won't be completely wiped out.

I also plan to semi-retire early and work a lower stress job between 40/50 and
65 so I'll be less under the gun than someone who _needs_ sell stock and can't
tighten their belt.

------
stcredzero
Aren't there any broad non-tech index funds?

~~~
yellowstuff
Looks like Pro Shares has S&P 500 ex Tech:
[http://www.proshares.com/funds/spxt.html](http://www.proshares.com/funds/spxt.html)

~~~
hendzen
ADV of 311 shares according to Yahoo. Do not buy.

