The future death of passive index tracking? Will the golden egged goose die from popularity?

SPC100

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Or to put it another way, can index tracking become so prevalent, that it will fail?

I think I first read about passive investing and using index trackers about 15 or 20 years ago. They were not very popular then. But they have been growing in popularity.

Today a very significant amount of new money invested in the market is money that is 'blindly' invested in shares via index trackers.

Is there a tipping point after which this will fail as a strategy for reliably getting top percentile returns?

We effectively rely on a wisdom of the crowd effect to price shares correctly and to reflect all known information. But if there is no crowd exercising their wisdom....e.g. if most actions of the crowd is just buying and selling based on being in an accumulation or distribution stage of their life, or because a company is added or removed from an index, or due to an emotional response to the world/market, how we ensure individual stocks are fairly priced?

If 100% of all new money invested in the stock market was blindly following index trackers, I would expect this to result in running up the price/valuation of companies that were listed in the major trackers, and result in companies that are not listed on the major index tackers being better value.

Wouldn't this depress future returns for index trackers?

For the record, I have been index tracking, and plan to continue to do so, but this question weighs more heavily in my mind, partially due to the shoeshine boy concern, as more and more people I talk to already know that you should just buy and hold a passive tracker.
 
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RedOnion

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There is lots of publications, with both sides of argument, about whether passive investment is making markets more or less efficient. Lots of reading if you've time to spare.

I think you're asking 2 questions (based on then shoeshine boy analogy).
1. Is there too much money in the stock market, and
2. Is the passive approach making markets inefficient in that investors aren't being selective in putting their money into good companies.
 

SPC100

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The shoeshine boy moment, is less about everyone wanting to invest, more that if I talk to people about investing, lots of them already know about passive diversified tracker being the 'best way to do it'.

Financial history/common sense indicate that anytime an edge was discovered, money chased it until the edge didn't exist. And while index tracking gives the market returns by definition, it has been delivering the edge of ensuring top percentile returns in a given market over the long term.

There are already threads about longest bull run in US, and the cheapness of other markets already active on aam, so I think that covers the 1. part.

I'd like to limit this thread to the market inefficiency concerns.

I can imagine this is a hot question for researchers, and I haven't seen a definitive convincing answer from casual reading, but I haven't had enough time to research this space - hence the question.
 
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EmmDee

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The shoeshine boy moment, is less about everyone wanting to invest, more that if I talk to people about investing, lots of them already know about passive diversified tracker being the 'best way to do it'.

Financial history/common sense indicate that anytime an edge was discovered, money chased it until the edge didn't exist. And while index tracking gives the market returns by definition, it has been delivering the edge of ensuring top percentile returns in a given market over the long term.

There are already threads about longest bull run in US, and the cheapness of other markets already active on aam, so I think that covers the 1. part.

I'd like to limit this thread to the market inefficiency concerns.

I can imagine this is a hot question for researchers, and I haven't seen a definitive convincing answer from casual reading, but I haven't had enough time to research this space - hence the question.
I don't think passive / tracker was ever thought to have an "edge" - it became a popular approach because it was felt there was no edge to be had in the market (or at least not in the long term). A lot of analysis shows active management may outperform in the short term but not consistently and therefore didn't justify the higher fee structures - are IM's performing any better than pure chance etc. Given active management fees can eat into overall returns quite significantly, a passive vehicle over time should provide adequate returns
 

galway_blow_in

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What option is there ?

Most are not smart enough to pick winners or enough to beat the market, relatively small number of companies drive market gains, plenty of companies in the s+p which are no higher today than thirty years ago
 

joe sod

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There are already threads about longest bull run in US, and the cheapness of other markets already active on aam, so I think that covers the 1. part.
thats true, but even if passive investing is just dumbly buying the market, you can still choose markets that are undervalued (of course you can be wrong just like picking individual stocks) to get an edge. By investing in passive funds you can still choose to dumbly invest in undervalued markets rather than dumbly buying overvalued markets.
However I get the logic the fewer investors that are actively seeking out individual stocks, are deciding the market and what constitutes an index, these "smart" investors are really leading a flock of sheep either into green pastures or arid desert
 

Jim2007

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I'd like to limit this thread to the market inefficiency concerns.
You are over thinking it. Index investing has nothing to do with whether or not the market is efficient. It just reflects the behaviour of a given market, it could not care less whether or not that market is efficient or not.

Whether or not passive investing will continue to yield results or not is a behavioural issue not an economic one. If people continue to measure performance based on a market index, then yes it most likely it will deliver reasonable results going forward.

Whether or not it will better or as good a result as other strategies is an entirely different question.
 

moneymakeover

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The total market capitalisation of s&p500

In 1957 it was 0.17 trillion
1980 1 trillion
Today 20 trillion

The question is: is it justified?

People pouring their 401k into the market is driving it up.

Of course there are other funds to track eg Russell small cap etc etc so it all balances out

Maybe the question is: when is the market overpriced versus underpriced?

When PE ratios go high and other indicators it's time to question the wisdom of the buy and hold philosophy.
 
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joe sod

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The total market capitalisation of s&p500

In 1957 it was 0.17 trillion
1980 1 trillion
Today 20 trillion

The question is: is it justified?
year 2000 16 trillion you forgot that but also very important.

you forgot one crucial statistic the capitalisation in year 2000, the S&P 500 is now only 27% higher than the year 2000 peak, it was 40% higher a month ago before the sell off.
Therefore the capitalisation in year 2000 was 16 trillion based on above figures. So most of the capitalisation of the S&P 500 was built up in the 1980s and 1990s. Therefore if the market was overvalued a whole 20 years ago is it still vastly overvalued today, maybe but its hardly the 1990s valuations.
 

cremeegg

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The total market capitalisation of s&p500

In 1957 it was 0.17 trillion
1980 1 trillion
Today 20 trillion
This is irrelevant as it makes no reference to the underlying changes in the business assets owned by holders of shares.

At a low point in 2003 a share in the S&P 500 represented ownership of businesses selling approx €900 (per share) today that figure is €1,300. I cannot find figures going back further than that. http://www.multpl.com/s-p-500-real-sales

This is to look at just one issue around valuation. Questions of profitability and future prospects are far more important, although harder to quantify.
 

Jim2007

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This is to look at just one issue around valuation. Questions of profitability and future prospects are far more important, although harder to quantify.
None of this matters in index investing, it is a mindless strategy of replicating a particular market in the expectation that one will achieve a result at least as good as the benchmark. It will continue to be seen as a successful strategy so long as investors continue to benchmark actively managed funds in the same way. Investors ask a simple question is my fund doing as well as the benchmark, if so then it stops there otherwise they switch. Even on the down turn so long as the fund looses value in line with its benchmark it will be considered a success from an investors point of view.

So long as the basic concept of benchmarking continues to be the accepted measurement of performance, index investing will continue on its merry way regardless of the underlying fundamentals.
 

cremeegg

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So long as the basic concept of benchmarking continues to be the accepted measurement of performance, index investing will continue on its merry way regardless of the underlying fundamentals.
I think the OPs point was that if everyone is benchmarking then the benchmark may come to underperform relative to active management.
 

SPC100

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Yes, Cremegg, that is roughly my point, or the benchmark might underperform compared to a buy and hold of some significant set share baskets (where the shares are not in the index)

Jim I take your point that the index is the index. So by buying it you get the index return. But If most or e.g. all money was blind money just buying the index, this would/should create a bubble in the price of the shares in the index, and it would likely not be a good long term strategy, to just buy the main index.

I read a bit about the subject and the opinion seems to be that as/if more money is blindly buying indexes, it would become easier for active investors to outperform, and more 'active' investors would get involved. e.g. if the p/e of the non indexed shares, was half that of the indexed shares, would you continue to buy the index?

As you mentioned Jim, What is the best strategy to get the best risk adjusted returns, is a different question. And IIUC, there is data about tilting towards small cap or value, that IIRC is meant to gives some higher returns than the main index (and higher risk). At some point, potentially tilting towards shares not in the main index might drive higher expected returns too.
 

moneymakeover

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According to Sven Carlin, Modern Value Investing

"At this moment in time, what few understand is that the huge increase in passive investment vehicles will become self-defeating because who is going to adjust market prices to new information if everybody invests in index funds? When there are only a few who perform fundamental analysis, they can’t move stock prices and they will continue moving according to their previous trends even if the fundamentals or the underlying business change."
 
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