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

[OhNoNotimAgain]

Goodhart’s Law states that when a measure becomes a target it ceases to be a good measure.

It was conceived in the 1980s when monetary policy was used to try and control inflation but the relationship between the two quickly diverged contrary to expectations. Subsequent examples have proliferated; most recently during Covid when the imperative to save the NHS resulted in more deaths at home. Again, not what was intended. However, the most glaring example has been staring us in the face for the past decade but has gone unrecognized.

Passive funds have existed since the 1970s but they have really only taken off in the last decade as the drive to cut costs and reduce risks has become more widely accepted. The concept looks harmless enough. If the bulk of the returns from an asset class, known as the beta, come from the asset class itself, whether that be UK, US equites or similar, rather than from the uncertainties of trying to pick stocks that might beat the market, known as alpha, why not just ditch the attempt to seek alpha and buy beta cheaply.

Indices themselves are of course a relatively recent phenomenon. There will still be a few market practitioners around today who remember the FT 30 before it was replaced by a variety of FTSE indices in the early eighties. Old indices like the DOW and the FT30 were designed just to give participants an idea of what was going on across the market as a whole but were really just a selection of the biggest names. At least the new indices, like the S&P and the FTSE, had the merit of having some rules and math’s behind them, although their composition can still be somewhat arbitrary. Nevertheless, like the indices they superseded, they were primarily designed to give a simple measure of what the market was doing overall. True, it wasn’t long before the real time aspects of the indices were captured by derivatives traders to make more money and, arguably, to add more liquidity to the system. But these indices were never designed as the target for an investment product. Because they were weighted by market capitalisation, they gave the largest positions to those companies with the highest value with no consideration of any underlying fundamentals such as balance sheets, cash flows or business prospects whatsoever. They gave a measure of what was most popular rather than what was most profitable.

So as index funds started to develop to follow these indices they followed the same process. New money coming into the fund was allocated in proportion to the size of company in the index. The largest companies received the largest allocation of new money invested with no consideration to fundamental factors.

Arguably this set the scene for some misallocation of funds. But the issue was small initially. Then came the financial crisis of 2007/8 when, to avoid multiple bank failures, the Bank of England, the Federal Reserve and most other central banks turned on the taps and printed money at a rate that can only be defined as stupendous. Once the banks had been “saved” the clear aim of that policy was to reinvigorate the economy by pushing investors out into longer duration assets such as long-term bonds and equities. And it worked. Long-term interest rates fell and equity markets reached new highs.

Then the Covid crisis hit and central banks once again reached for the only tool they had; printing money. The precise amount created is hard to quantify but it is nearly a trillion pounds for the UK and about nine trillion dollars for the US.
This ocean of money had to go somewhere and clearly much has gone into equity markets. The UK market is worth £2 trillion so it has benefitted from the marginal pound invested. The same argument applies, but more so, in the US where recent volatility in the share prices of some large companies shows that there is now a very loose connection between the economic prospects of a company and its market value.
Quantative Easing, and its sister policy of Zero Interest Rates, mean that the opportunity cost of investing in growth stocks is low. Indeed, the popularity of meme stocks and green themes, like electric vehicles, has made some areas of the market more an avenue for virtue signaling than investing. More than ever growth stocks flag a company’s popularity more than its profitability which further disconnects its value from its economic fundamentals. Once that link is broken the valuations can swing wildly as sentiment changes, as recent market moves have demonstrated.
The idea that investors, and intermediaries, can simply invest their assets across the asset class by allocating funds according to price is logically flawed. And the consequences of it are only just being revealed.

The danger of market capitalisation index funds is that they are disconnected from financial reality, and they echo Oscar Wilde’s quote of knowing the price of everything but the value of nothing. Something that surely could not be said of Professor Charles Goodhart. Tying an investment product to a measure that was not designed for such a purpose is unlikely to end well.

And this is where Goodhart’s Law shows it true brilliance. 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. 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.

[Hariseldon58]

Lack of logic in developing an argument, the OP has an axe to grind on this topic from his previous postings…


Good interview on recent Moneyweek podcast with Merryn Somerset Webb talking to the author of Trillons,Robin Wigglesworth. This topic was discussed at some length and some sensible and logical discussion, pros and cons.

The book is good, a deep dive into indexing

[minnow]

yeah, I'm not sure I buy the argument. *If* (big if) index investors are systematically driving up the prices of growth stocks, wouldn't that be good news for value investors who get the opportunity to buy unloved stocks on the cheap ? And it's not like market-cap weighted indices are the only type that exist, what about equal-weight, inverse-weighted, smart beta etc ?

[Newroad]

Hi HariSeldon.

I broadly share your assessment of the both the original post (not that well a developed argument) and that Wrigglesworth's book* is worth a read (although I don't think it forms an opinion on the salient part of this discussion - rather, it focuses perhaps on the views of other key players relating to this, e.g. Bogle). However, a poorly formed (and/or somewhat verbose argument) doesn't make it necessarily wrong.

There is an argument that index-investing is broadly the same as momentum investing. There is an argument that momentum investing can be successful. There is also an argument that investing in high dividend yield companies can be successful. My take broadly is that the former is more of a short term consideration, the latter a long term one.

Whatever the case, I'm not sufficiently convinced to go one way or the other (or some other way) - so within each of my asset classes I'm generally 50% passive (Index Tracking ETF's) and 50% active (Investment Trusts). Actually, this is not quite true with bonds anymore - is closer to 65% passive and 35% active, but the principle broadly remains - this varied split is more about investment-grade (via the passive) and junk-bonds (via the investment trusts).

So, I probably won't get all the gain on the way up or all the pain on the way down - and I'm mildly hopeful that I get some longer term small uplift from rebalancing assuming a form of mean reversion.

Regards, Newroad

* can't comment on the podcast referred to

[scrumpyjack]

I really don't buy the argument that passive investing is significantly distorting markets. That would only be the case if it was greatly increasing demand for one share compared to others, but by definition it isn't. It could be argued that it amplifies the effect of active investing because relative price changes will occur due to the activity of the few remaining active investors. The demand from passive investors is like the tide, raising or lowering all boats equally!

Of course active managers have an axe to grinds in that the greater the market share that passive investing takes, the smaller the fees being paid to active managers.

[vand]

I think the truth is that no one really has a good idea to what extent passive indexing is impacting markets - I mean, how on earth would you model something like that?!

That said, markets are always changing, and it would be naive to think that we would be operating in a perfect market with perfect knowledge and rational players even if there weren't any index funds. Things like HFT and derivatives have been increasingly influencing markets for a long time now.

But whether you stick to index funds or pick individual stocks I think the basics of being a good long term investor are no different - a deep understanding of yourself, patience, consistency, and the ability to keep a cool and clear head when everyone else seems to be losing theirs.

I predict we will see a shift back to actively managed money after a period of lousy market returns - not because I expect most active funds to all of a sudden start beating the market, but because of how human psychology works. When market returns are good and driven by a tiny number of megacaps which are almost impossible to beat, then indexing is a both a sensible option and a "greedy" option. But when recent market returns are rubbish then you are more likely to take a chance with active management to give you a chance of a decent return, and to give you a different narrative to pursue. Additionally, you will see stories of funds that x10 because they've been invested in the right sector, and this will sound even more enticing to people whose index returns have been performing poorly for a long time.

[Dod101]

I really don't buy the argument that passive investing is significantly distorting markets. That would only be the case if it was greatly increasing demand for one share compared to others, but by definition it isn't. It could be argued that it amplifies the effect of active investing because relative price changes will occur due to the activity of the few remaining active investors. The demand from passive investors is like the tide, raising or lowering all boats equally!

Of course active managers have an axe to grinds in that the greater the market share that passive investing takes, the smaller the fees being paid to active managers.

I wonder if anyone has ever tried to assess the share of active v passive investing?

Dod

[Newroad]

Yes, Dod.

Here's one - already over a year old - I think passive has made significant gains since then.

https://www.bloomberg.com/professional/blog/passive-likely-overtakes-active-by-2026-earlier-if-bear-market/

with the most salient quote probably being

"It’s only a matter of time before passive assets overtake active in U.S.-based mutual funds and ETFs. The 42.9% of assets, or about $10 trillion, managed passively are up from 31.6%, or $4.1 trillion, at the end of 2015. Discretionary active funds handle the remaining 57% — about $13.3 trillion of the $23.3 trillion in total fund assets."

Other sources are available.

Regards, Newroad

[NotSure]

I'm not qualified to comment on the OP hypothesis, just a comment about the exact definition of a 'passive investor'. In USA, I would guess this is someone is 100% S&P tracker? (However, if time is on their side, or they have higher risk tolerance, an allocation to Nasdaq or EM may be in order). In UK, it may mean a FTSE100 tracker, or perhaps a FTSE AllShare, or these days a global tracker, perhaps with, perhaps without EM included.

My point is that I would guess few are truly passive, even if all they hold are trackers. Is not passive vs active a bit of a false dichotomy? Some are certainly truly active, holding only hand picked shares (or trusts with shares hand-picked by professionals). But how many, Warren Buffet's wife aside, are 'truly' passive? Even she has chosen to go with a particular index in a single country. (I am referring to WB's famous advice to his wife to shove the lot in an S&P500 tracker should she outlive him).

[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.

[JohnW]

So as index funds started to develop to follow these indices they followed the same process. New money coming into the fund was allocated in proportion to the size of company in the index. The largest companies received the largest allocation of new money invested with no consideration to fundamental factors.

Arguably this set the scene for some misallocation of funds.

Well, you’d better make the argument. Because as I see it, if there’s a flood, trickle or whatever of new money coming into the market and spread around on the basis of company capitalisation, then all the stocks in the index will rise by the same proportion; no market distortion, one company compared with another, at all.
If there is, as a consequence of that flood or trickle, now an overpricing of all stocks in the index, then there are rich pickings for the thousands of active funds and millions of individual active investors to sell those overpriced stocks and make a killing. It’s active investors, and money printing governments who are responsible for any mis-pricing.
If there are mis-priced individual stocks in the market, like big tech or loss-making something elses, then it’s the active investors who are responsible for not fixing those mis-pricings by selling (or buying).

[tjh290633]

I think that the point which has been missed, is that the shares in the market do not move as one. Over the course of a year, some shares rise and some fall. The market might do little or a lot, as indicated by the indices. The FT30 was mentioned earlier. The 30 constituents are seldom changed, except if one is taken over or goes bust. It really reflects an extreme example of a buy and hold portfolio with an odd weighting system. Currently under 3,000, it has lagged the FTSE100 for a good few years, but the FTSE100 is a bit like Trigger's broom. Companies enter and leave at the whim of the market. I forgot, the index is the market you would have us believe.

I have commented elsewhere in the past on the differences in share price movements from one year to the next. Last year's loser may be this year's winner. Looking further afield, the FTSE250 has tended to outperform the FTSE100 and FTSE350. The FTSE350HY has led the FTSE350LY in terms of Total Performance and, for some time in capital performance.

I contend that indiscriminate index following misses a lot of the advantages, that a sensible targeted investing approach can capture.

TJH

[dealtn]

The FTSE350HY has led the FTSE350LY in terms of Total Performance and, for some time in capital performance.

It really depends one when you choose your start date to make that claim, and what you mean by leading. Over the last 22 years, the period over which I can access data for those Total Return indices, for only 5 of those periods since that annual start date has the High Yield Index outperformed the Low Yield one when you measure from then to now. (Since 1999, 2000, 2019, 2020 and 2021 if anyone is interested).

[tjh290633]

The FTSE350HY has led the FTSE350LY in terms of Total Performance and, for some time in capital performance.

It really depends one when you choose your start date to make that claim, and what you mean by leading. Over the last 22 years, the period over which I can access data for those Total Return indices, for only 5 of those periods since that annual start date has the High Yield Index outperformed the Low Yield one when you measure from then to now. (Since 1999, 2000, 2019, 2020 and 2021 if anyone is interested).

Yes, but I was looking at the figures from inception. I agree that there have been recent periods when LY has been the better performer.

TJH

[GoSeigen]

So as index funds started to develop to follow these indices they followed the same process. New money coming into the fund was allocated in proportion to the size of company in the index. The largest companies received the largest allocation of new money invested with no consideration to fundamental factors.

Arguably this set the scene for some misallocation of funds.

Well, you’d better make the argument. Because as I see it, if there’s a flood, trickle or whatever of new money coming into the market and spread around on the basis of company capitalisation, then all the stocks in the index will rise by the same proportion; no market distortion, one company compared with another, at all.
If there is, as a consequence of that flood or trickle, now an overpricing of all stocks in the index, then there are rich pickings for the thousands of active funds and millions of individual active investors to sell those overpriced stocks and make a killing. It’s active investors, and money printing governments who are responsible for any mis-pricing.
If there are mis-priced individual stocks in the market, like big tech or loss-making something elses, then it’s the active investors who are responsible for not fixing those mis-pricings by selling (or buying).

A plague on both your houses I say. The amount of money "coming into the market" has practically no bearing on the price of the stocks in that market. In fact how can money "come into the market"? Money is money and stocks are stocks. Neither comes in and neither goes out. Just the rate of exchange between the two changes and that is independent of the volume of buying or selling -- or demand if you wish to use that word.

Just think for a moment. A bond of £1bn is issued. It doesn't matter if one bond is bought in the secondary market or 100m of them. If the market (buyers and sellers) values the bonds at 2% yield then that is where the price will end up. Stocks are no different.

The problem with lots of passive buying of index funds is not to do with the flow of money; it is that fact that the buyers don't care what price they are paying for the individual constituents of the index and therefore mispricing is almost certain to happen on a habitual basis.

Similarly, active investors cannot "fix" mispricing merely by buying or selling. They can only do so by changing the price at which they trade. Now by definition the active investors as a group are better at pricing the assets than passive investors. So why would they volunteer to change the price? They will wait until the passive investors are happy to change THEIR price (i.e. willing to trade at the price the active traders want) and then the price will move to the right value. It's really a very similar dynamic to the smart money/dumb money one.

GS

[vand]

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.

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.

[OhNoNotimAgain]

.

The problem with lots of passive buying of index funds is not to do with the flow of money; it is that fact that the buyers don't care what price they are paying for the individual constituents of the index and therefore mispricing is almost certain to happen on a habitual basis.

GS

Absolutely correct on the second point, wrong on the first point as anyone who has tried to deal in illiquid stocks will know.

That was why on the floor of the exchange brokers would ask the price in "X" and the jobber would reply " 15 -16 in 10, 14 to 17 in larger size"

[Dod101]

Lack of logic in developing an argument, the OP has an axe to grind on this topic from his previous postings…


Good interview on recent Moneyweek podcast with Merryn Somerset Webb talking to the author of Trillons,Robin Wigglesworth. This topic was discussed at some length and some sensible and logical discussion, pros and cons.

The book is good, a deep dive into indexing

I mentioned it some weeks back but no one took me up on it. A book well worth reading, in my opinion. Merryn Somerset Webb is also good.

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.

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.

That is something I have often thought as well. Passive investing is really a form of derivative, the underlying issue being active investors creating a market in the first place. So in the end the passive investors could be the authors of their own misfortune.

Dod

[GoSeigen]

.

The problem with lots of passive buying of index funds is not to do with the flow of money; it is that fact that the buyers don't care what price they are paying for the individual constituents of the index and therefore mispricing is almost certain to happen on a habitual basis.

GS

Absolutely correct on the second point, wrong on the first point as anyone who has tried to deal in illiquid stocks will know.

That was why on the floor of the exchange brokers would ask the price in "X" and the jobber would reply " 15 -16 in 10, 14 to 17 in larger size"

This is a very difficult topic, I acknowledge, so it requires either a sharp intelligence or clarity and careful application of thought to process. (And as Jung famously observed, "Thinking is difficult, therefore let the herd pronounce judgment"; it's understandable that the herd gets this wrong and ends up overpaying for shares or selling them too cheaply.)

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".

It's important but difficult not to confuse these issues; indeed I'm very doubtful my own explanation is clear enough to convince anyone.


GS