QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

[NotSure]

The concern is that if all future money goes towards indexing then there is no active price discovery for individual securities. You have nobody deciding if Vodafone should be worth 2 times BT, or 5 times BT, of if Tesco should be worth 2 time Sainsbury or 5 times Sainsbury. Everyone takes it as gospel that relative prices are all correct. That itself is not healthy for capitalism, which relies of price discovery via the market forces to allocate resources efficiently.

Passive investing absolutely requires active investors. The opposite is not true.
Even Bogle himself said if everyone indexed there would be complete chaos.

Just looking at a single day, last Friday, on the S&P500, which I'm guessing is the most tracked index (in absolute terms, though maybe not in relative terms)?

Anyway, the index as a whole was down 0.6%

Top three risers were up 9.8%, 7.1% and 7.0% respectively. Top three fallers were -25.9%, -23.8% and -19.1%.

That's in a single, not particularly eventful day.

As such, I suspect the 'passive apocalypse' is still a little way off.

[Dod101]

So in the end the passive investors could be the authors of their own misfortune.

Dod

Like democracy and Brexit.

I do wish that posters would try, at least, to keep politics in their place. And it is very tiresome to have the Brexit word introduced into almost every discussion on these Boards.

Dod

[Dod101]

The danger of market capitalisation index funds is that they are disconnected from financial reality,

No it is the complete opposite.

Money in an indexed fund will perform (and be adjusted) in line with that index which broadly speaking is adjusted by the market in line with financial reality over time.

Only of course if there are sufficient active investors to make it so.

Dod

[Dod101]

An interesting point in the 'Trillions' book is, as the author tells us, that passive investors have subcontracted stock picking to the index funds themselves. We can see this when the FTSE100 reviews its constituents each quarter, usually removing the smallest by marketcap and replacing them with those which have grown bigger by the same measure.

And just to emphasise the point, the more passive funds hold of any one index, the less meaningful will be the result, because obviously if passive funds increase their percentage holding, the proportion held by active funds will reduce and it is the active funds that produce the market price of individual shares.

Dod

[GeoffF100]

Most people believe what they want to believe. People want to believe that they can beat the market. There will always be active investors.

People claim that buying a market market weighted trackers pushes up the value of the larger stocks. That is complete nonsense, but people want to believe it.

You can overweight small stocks. Where do you get them? The market weighted trackers will not sell them to you. They buy and hold. If those funds have redemptions, the underlying stock will be sold in market weights (with no excess small caps). You get only get excess small caps from active investors who think they are over priced. Do you know more than they do? Active investors believe they do, or succeed in conning someone else into believing that they do.

[OhNoNotimAgain]

It would help not to conflate two separate things: the market price of a security is NOT the several prices being offered or bid by a willing trader. It is the ACTUAL SINGLE price at which a transaction has taken place. Furthermore, that transaction at that single price is simultaneously a sale and a purchase. In contrast, the bids and offers made by a trader are each for only ONE SIDE of the trade; a market price is only determined once a second party is willing to meet the first with the other side of the trade. Those four prices in your example are complete red herrings, they might never be achieved and thus contribute nothing to knowledge of the actual "market price".


GS

Partially correct.

But when the transaction is made that then becomes the latest price.
If the trade is made at 16p in 10k then that is the price.
But if the volume is 20k shares then the price is 17p.

Volume does influence price, as any broker trying to place stock knows.

[OhNoNotimAgain]

The danger of market capitalisation index funds is that they are disconnected from financial reality,

No it is the complete opposite.

Money in an indexed fund will perform (and be adjusted) in line with that index which broadly speaking is adjusted by the market in line with financial reality over time.

No, that does not happen. No one "adjusts" holdings in a passive mkt cap index fund. Stocks go up or down and so does the value of the fund holding. The only adjustments are made when the index is changed. In terms of the fund it trades in proportion to the index when money comes in or goes out.

[OhNoNotimAgain]

An interesting point in the 'Trillions' book is, as the author tells us, that passive investors have subcontracted stock picking to the index funds themselves. We can see this when the FTSE100 reviews its constituents each quarter, usually removing the smallest by marketcap and replacing them with those which have grown bigger by the same measure.

And just to emphasise the point, the more passive funds hold of any one index, the less meaningful will be the result, because obviously if passive funds increase their percentage holding, the proportion held by active funds will reduce and it is the active funds that produce the market price of individual shares.

Dod

Don't forget that a lot of active funds are in fact "closet trackers" becuase they don't want to deviate too much from the crowd. They would rather underperform collectively than take the risk of shooting for the starts and then failing. This board will know the names of those fund managers that deviated a lot from the index, took in a lot of money and then crashed and burned.

[Dod101]

An interesting point in the 'Trillions' book is, as the author tells us, that passive investors have subcontracted stock picking to the index funds themselves. We can see this when the FTSE100 reviews its constituents each quarter, usually removing the smallest by marketcap and replacing them with those which have grown bigger by the same measure.

And just to emphasise the point, the more passive funds hold of any one index, the less meaningful will be the result, because obviously if passive funds increase their percentage holding, the proportion held by active funds will reduce and it is the active funds that produce the market price of individual shares.

Dod

Don't forget that a lot of active funds are in fact "closet trackers" becuase they don't want to deviate too much from the crowd. They would rather underperform collectively than take the risk of shooting for the starts and then failing. This board will know the names of those fund managers that deviated a lot from the index, took in a lot of money and then crashed and burned.

That is a good point. Mostly they do not want to deviate far from their benchmarks, or they will introduce volatility, just as Scottish Mortgage does. Most contrarian managers do not last that long because their bosses want steady earnings for the fund management company. Stepping out of line can produce long barren spells sometimes followed by spectacular growth. Not at all what the average, publicly quoted, fund manager wants.

Dod

[dealtn]

The danger of market capitalisation index funds is that they are disconnected from financial reality,

No it is the complete opposite.

Money in an indexed fund will perform (and be adjusted) in line with that index which broadly speaking is adjusted by the market in line with financial reality over time.

No, that does not happen. No one "adjusts" holdings in a passive mkt cap index fund. Stocks go up or down and so does the value of the fund holding. The only adjustments are made when the index is changed. In terms of the fund it trades in proportion to the index when money comes in or goes out.

We are agreeing them. I made no claims that anybody does the adjusting. The values of the individual holdings (and the funds valuation) adjust in line with the financial reality the market places on it. Your claim is there is a disconnect with financial reality. That simply isn't true.

[GoSeigen]

It would help not to conflate two separate things: the market price of a security is NOT the several prices being offered or bid by a willing trader. It is the ACTUAL SINGLE price at which a transaction has taken place. Furthermore, that transaction at that single price is simultaneously a sale and a purchase. In contrast, the bids and offers made by a trader are each for only ONE SIDE of the trade; a market price is only determined once a second party is willing to meet the first with the other side of the trade. Those four prices in your example are complete red herrings, they might never be achieved and thus contribute nothing to knowledge of the actual "market price".


GS

Partially correct.

But when the transaction is made that then becomes the latest price.
If the trade is made at 16p in 10k then that is the price.
But if the volume is 20k shares then the price is 17p.

Volume does influence price, as any broker trying to place stock knows.

Okay, the price of the trade was 17p. Was there a high volume of buying or a high volume of selling?

GS

[OhNoNotimAgain]

Your claim is there is a disconnect with financial reality. That simply isn't true.

Really? I am trying to think to think of the best way to evidence that. It is a target rich environment.

[hiriskpaul]

Proponents of cap weighted indices can argue that allocating money by price, leading to generous valuations for the larger “growth” companies, is just how the market works.

Let's break that down:

Proponents of cap weighted indices can argue that allocating money by price, ..., is just how the market works.

The market provides prices for each stock. Price times number of shares available in the market is the total value of the company, or to be more precise, the value of all the freely available shares. Add up for all companies in the market and you get the total value of the market - the "free float" value. A cap weighted tracker is designed to move in lock-step with that total market value. Nothing more, nothing less. Proponents of cap weighted indices DO NOT allocate money by price. That is arithmetic gibberish. They allocate by "free float" value. They cannot allocate any other way because if they did the index would not move in lock-step with the market. Now maybe "price" here is being used for "free float value". If not it is nonsense.

.. leading to generous valuations for the larger “growth” companies ..

Complete bunkum. Apart from their not being a mechanism to drive this outcome, let's just think about the repercussions of this for the moment if it was true. If cap weighted investment funds consistently drove up the value of higher cap companies relative to lower ones, that would create an amazing opportunity for active fund managers. Yet the long term track record shows that index funds outperform the vast majority of active funds in the long term. So either active managers are too stupid to exploit the opportunity being presented to them on a plate by passive investors or the opportunity does not exist. In fact the opportunity cannot exist because the actively managed share of the market is also cap weighted! In other words the actively managed share of the market fluctuates in value in lock-step with cap weighted share. An active fund manager can only outperform cap weighted funds at the expense of other active market participants, NOT at the expense of cap weighted funds.

However, the impact on those with fiduciary duties who see funds with a bias to value lagging the index, now distorted by index funds, is pressure to move money away from value funds to those with a growth bias. And that further exaggerates the effect. So now the index has indeed become the target, the index itself has become less meaningful.

If value investors are choosing to move away from value companies, or to be more precise, allocate lower valuations to them, that is as a result of active decisions by active market participants. Nothing whatever to do with cap weighted index investors.

[OhNoNotimAgain]

Proponents of cap weighted indices can argue that allocating money by price, leading to generous valuations for the larger “growth” companies, is just how the market works.

Let's break that down:

Proponents of cap weighted indices can argue that allocating money by price, ..., is just how the market works.

The market provides prices for each stock. Price times number of shares available in the market is the total value of the company, or to be more precise, the value of all the freely available shares. Add up for all companies in the market and you get the total value of the market - the "free float" value. A cap weighted tracker is designed to move in lock-step with that total market value. Nothing more, nothing less. Proponents of cap weighted indices DO NOT allocate money by price. That is arithmetic gibberish. They allocate by "free float" value. They cannot allocate any other way because if they did the index would not move in lock-step with the market. Now maybe "price" here is being used for "free float value". If not it is nonsense.

.. leading to generous valuations for the larger “growth” companies ..

Complete bunkum. Apart from their not being a mechanism to drive this outcome, let's just think about the repercussions of this for the moment if it was true. If cap weighted investment funds consistently drove up the value of higher cap companies relative to lower ones, that would create an amazing opportunity for active fund managers. Yet the long term track record shows that index funds outperform the vast majority of active funds in the long term. So either active managers are too stupid to exploit the opportunity being presented to them on a plate by passive investors or the opportunity does not exist. In fact the opportunity cannot exist because the actively managed share of the market is also cap weighted! In other words the actively managed share of the market fluctuates in value in lock-step with cap weighted share. An active fund manager can only outperform cap weighted funds at the expense of other active market participants, NOT at the expense of cap weighted funds.

However, the impact on those with fiduciary duties who see funds with a bias to value lagging the index, now distorted by index funds, is pressure to move money away from value funds to those with a growth bias. And that further exaggerates the effect. So now the index has indeed become the target, the index itself has become less meaningful.

If value investors are choosing to move away from value companies, or to be more precise, allocate lower valuations to them, that is as a result of active decisions by active market participants. Nothing whatever to do with cap weighted index investors.

Interesting post with lots of good points.

You are quite correct about the "free float" point. However, it should not matter to an investor who owns the rest of a company, whether it is other funds, the founders or overseas holders. All he wants is to participate in the financial return of the company and decide what proportion of his portfolio to allocate to it. Illiquidity due to limited free float is a well known way of pushing up valuations. When that happens the mkt cap tracker naturally follows and new money is allocated accordingly in line with the free float adjusted index weight, irrespective of any considerations of value or economic return.

You are incorrect to say that over the long term index funds funds outerform the majority of active funds. The best data set I can find shows that the best performing all market UK (i.e. not 250) passive fund over 10 years is ranked 101st out of 190. Not even in the top half.

[Bubblesofearth]

Anyone investing in cap weighted trackers could do worse than look at the record of equal weight investing, value investing and small cap investing because all of these have beaten cap weight investing over long periods of time. Value and small cap premiums are well covered by the work of Dimson et al in 'Triumph of the Optimists' and in subsequent work.

the poor performance of active funds vs passive is a bit of a red herring as the bulk of that underperformance is down to higher charges not poor stock selection criteria.

The usual reason I've seen given for the outperformance of non-cap weighting is acceptance of higher risk but this doesn't track when you look at correlation between stocks and how diversification lowers risk.

What is interesting is that outperformance vs cap-weight pre-dates the advent of passive trackers and therefore must be explained by another mechanism. Most likely IMO this has to do with poor appreciation of risk vs reward. A long time ago this had investors shunning equities for bonds and perhaps segued into the preference for big cap stocks vs their smaller cousins.

IMO Passive investing performs well because of low charges not because it is necessarily the best way to allocate money in stocks. It may be that trackers accentuate this misallocation but confess I'm not sure of the maths.

BoE

[OhNoNotimAgain]

the poor performance of active funds vs passive is a bit of a red herring as the bulk of that underperformance is down to higher charges not poor stock selection criteria.


BoE

That's what conventional passive fund managers want you to believe and they have done a good job at making that pitch.

But the data does not support that argument.

Over 10 years the best performing UK fund is up 249% while the best performing UK tracker is up 97%. That difference is not accounted for by charges but by risk appetite as you point out.

QE has created so much money that it has inflated the prices of the riskiest and most illiquid assets.

[hiriskpaul]

Proponents of cap weighted indices can argue that allocating money by price, leading to generous valuations for the larger “growth” companies, is just how the market works.

Let's break that down:

Proponents of cap weighted indices can argue that allocating money by price, ..., is just how the market works.

The market provides prices for each stock. Price times number of shares available in the market is the total value of the company, or to be more precise, the value of all the freely available shares. Add up for all companies in the market and you get the total value of the market - the "free float" value. A cap weighted tracker is designed to move in lock-step with that total market value. Nothing more, nothing less. Proponents of cap weighted indices DO NOT allocate money by price. That is arithmetic gibberish. They allocate by "free float" value. They cannot allocate any other way because if they did the index would not move in lock-step with the market. Now maybe "price" here is being used for "free float value". If not it is nonsense.

.. leading to generous valuations for the larger “growth” companies ..

Complete bunkum. Apart from their not being a mechanism to drive this outcome, let's just think about the repercussions of this for the moment if it was true. If cap weighted investment funds consistently drove up the value of higher cap companies relative to lower ones, that would create an amazing opportunity for active fund managers. Yet the long term track record shows that index funds outperform the vast majority of active funds in the long term. So either active managers are too stupid to exploit the opportunity being presented to them on a plate by passive investors or the opportunity does not exist. In fact the opportunity cannot exist because the actively managed share of the market is also cap weighted! In other words the actively managed share of the market fluctuates in value in lock-step with cap weighted share. An active fund manager can only outperform cap weighted funds at the expense of other active market participants, NOT at the expense of cap weighted funds.

However, the impact on those with fiduciary duties who see funds with a bias to value lagging the index, now distorted by index funds, is pressure to move money away from value funds to those with a growth bias. And that further exaggerates the effect. So now the index has indeed become the target, the index itself has become less meaningful.

If value investors are choosing to move away from value companies, or to be more precise, allocate lower valuations to them, that is as a result of active decisions by active market participants. Nothing whatever to do with cap weighted index investors.

Interesting post with lots of good points.

You are quite correct about the "free float" point. However, it should not matter to an investor who owns the rest of a company, whether it is other funds, the founders or overseas holders. All he wants is to participate in the financial return of the company and decide what proportion of his portfolio to allocate to it. Illiquidity due to limited free float is a well known way of pushing up valuations. When that happens the mkt cap tracker naturally follows and new money is allocated accordingly in line with the free float adjusted index weight, irrespective of any considerations of value or economic return.

You are incorrect to say that over the long term index funds funds outerform the majority of active funds. The best data set I can find shows that the best performing all market UK (i.e. not 250) passive fund over 10 years is ranked 101st out of 190. Not even in the top half.

I will come back on your other points later, but with respect to the top performing UK all market fund, on Morningstar iShares UK Equity Index Fund (UK) D Acc is in position 139 of the 319 funds that have a 10 year record and HAVE NOT CLOSED. the next is an HSBC all share tracker at 141. So ignoring survivorship bias, which takes out higher proportions of poor performers that is still in the top half.

I would agree though that UK trackers have not done well over the last 10 years and there is a reason for that. Many UK funds are permitted to invest in non-UK shares. World ex UK has done much better than UK, so this ability to invest outside the UK has enabled UK actively managed funds to do better than they otherwise would have had they stuck to UK only. Compare with a market where the ability to invest outside the index has not helped performance such as the US market. SPIVA, which correct for survivorship bias, says that 83% of funds underperformed the S&P 500 over 10 years:

https://www.spglobal.com/spdji/en/resea ... /spiva/#us

In addition to the fact that most active funds underperform over the long term, there is a lack of persistance in those that do outperform:

https://www.spglobal.com/spdji/en/spiva ... -scorecard

This lack of persistance means you might as well flick a coin in attempting to pick an active fund, or just pick an index fund as that approach has consistently delivered long term outperformance. Not the best, just better than average and increasingly better the longer you hold it.

[hiriskpaul]

You are quite correct about the "free float" point. However, it should not matter to an investor who owns the rest of a company, whether it is other funds, the founders or overseas holders. All he wants is to participate in the financial return of the company and decide what proportion of his portfolio to allocate to it. Illiquidity due to limited free float is a well known way of pushing up valuations. When that happens the mkt cap tracker naturally follows and new money is allocated accordingly in line with the free float adjusted index weight, irrespective of any considerations of value or economic return.

Right, so we are agreed that if company A has a free float of $1T and company B $1B a cap weighted index fund would buy $1m of A for every £1k of B. Now you say "Illiquidity due to limited free float is a well known way of pushing up valuations". Hardly well known as this is first time I have heard of it. Can you point towards evidence or is this just a new spurious accusation made by active managers attempting to undermine index funds? As before, if this was true then it presents an opportunity for active fund managers to make money at the expense of index funds, which as I have previously explained cannot happen.

[hiriskpaul]

Anyone investing in cap weighted trackers could do worse than look at the record of equal weight investing, value investing and small cap investing because all of these have beaten cap weight investing over long periods of time. Value and small cap premiums are well covered by the work of Dimson et al in 'Triumph of the Optimists' and in subsequent work.

Factor investing is not foolproof. There have been extended periods where it does not work, eg the past 10+ years for value investing. There are also additional costs invovled in factor investing, so these additional costs need to be returned before any benefit to the investor can be realised. For investors there are always going to be doubts as well - Has the market now incorporated the information now available on value investing, etc. into share prices?

the poor performance of active funds vs passive is a bit of a red herring as the bulk of that underperformance is down to higher charges not poor stock selection criteria.

The usual reason I've seen given for the outperformance of non-cap weighting is acceptance of higher risk but this doesn't track when you look at correlation between stocks and how diversification lowers risk.

In aggregate the under performance of active funds is entirely due to higher charges and costs as the aggregate of active funds is weighted the same way as cap weighted trackers. But that doesn't explain the distribution of returns amongst active funds - why so many of them under perform over any given time period. An interesting paper from Vanguard a few years ago put much of that down to lack of diversification and the fact that the majority of stocks underperform the market as a whole. I would provide a link, but Vanguard seem to have changed their website so my link no longer works!

What is interesting is that outperformance vs cap-weight pre-dates the advent of passive trackers and therefore must be explained by another mechanism. Most likely IMO this has to do with poor appreciation of risk vs reward. A long time ago this had investors shunning equities for bonds and perhaps segued into the preference for big cap stocks vs their smaller cousins.

IMO Passive investing performs well because of low charges not because it is necessarily the best way to allocate money in stocks. It may be that trackers accentuate this misallocation but confess I'm not sure of the maths.

Or it could be down to data mining. If you go looking for outperforming strategies in historic data you will inevitably find some. What about the underperforming strategies that have been quietly ignored?

If company A has 10 times the market cap of B, I really cannot see how an index fund putting ten times as much money into A's shares than B's shares disproportionately increasing the value of A's shares compared to B's. If equal weighted funds became very popular, then I can see that would drive up the value of smaller cap companies relative to larger caps, but this mechanism cannot work for cap valued index funds.

It is a few years old, but you might find this paper on equal weighted indexes interesting https://www.spglobal.com/spdji/en/resea ... t-indices/

[Bubblesofearth]

That's what conventional passive fund managers want you to believe and they have done a good job at making that pitch.

But the data does not support that argument.

Over 10 years the best performing UK fund is up 249% while the best performing UK tracker is up 97%. That difference is not accounted for by charges but by risk appetite as you point out.

QE has created so much money that it has inflated the prices of the riskiest and most illiquid assets.

That's n=1 data. One time period and one fund. Utterly meaningless as a comparator of likely future performance of active vs passive. From what I've read not only does passive outperform active on aggregate (mostly due to higher charges) but there is also no consistency in performance of active.

BoE