Guys like warren buffet, large PE firms, and short selling activists will clean up. Basically anyone who trades/invests in companies (as opposed to investing/trading in stocks). Good companies will become undervalued and bad companies will be overvalued.
Sure one could of done that but the result you get has nothing to do with the index itself. But everything to do with the underlying companies. I think people are confused on this thread about how index ETFs work. And how institutional market makers Arbitrage the difference between the price of the underlings versus the market price of the etf index.
If you've ever seen that Sik guy on cnbc with the motif fund, I think a fun motif would be the S&P 500 ex fund in which you can buy the index minus what ever stocks you choose. For example some just don't like tobacco, others don't like UAL. Just put a check in the box and you own everything but what you have checked and you can uncheck any time.
I disagree - ETFs were passive holders of Bear Stearns et al leading up to their removal from the index. Then suddenly they were forced sellers when the index committee removed them from the index. .
I'm not sure what your point is? Indexes drop companies and add companies all the time. The actual impact of indexes doing so has gotten so small on the valuation of a stock that the opportunity to profit and arbitrage has almost gone away. In addition, there are plenty of examples of stocks being added to an index and it goes down and vice versa, stocks being dropped from the index and it goes up. Where's the opportunity you talk about regarding buying SPY and shorting financials aka bear stearns? And why would you have bought SPY and shorted bear stearns et al.? All you have essentially done is gone long relative strength (indexes not moving as much as bear stearns, and short relative weakness. You are still maintaining a bias thus directional trade, but diluting any potential earnings with a hedge. A better trade would have been to just short bear stearns or the financials, but if you wanted to maintain market neutrality, than you could of paired bear stearns with a JPM and played the spread. But again you would have had to get your long short positions correct. If you could offer up some further information, perhaps I would understand.
Probably just my clumsy way of saying that even if a stock is heading towards zero, index funds continue to hold it right up until the moment the index committee removes it from the relevant index. The holders of that stock are doing so because of an investment mandate, and not because of an active investing decision. Therefore it provides an opportunity to those who trade/invest on fundamentals to short that stock at a price that is artificially higher than what it would be without those passive holders. .
But one could do that whether it's in the index or not in the index. I think you are saying inclusion in the index artificially inflates valuations of its components and even vice versa. I'm saying that isn't necessarily the case. Any spread between the index NAV and the market price of the index is arbitraged by institutional traders who are authorized to do so. For example if IWM is trading at 130, but the underlying assets have an NAV of 129.50, authorized ETF traders will buy the components create an etf share at NAV and than sell the etf index or vice versa. This happens extremely quickly and nearly impossible for smaller traders to do. This also provides liquidity and efficient pricing. It's also a myth to think passive index ETFs are passive investments. Indexes get rebalanced and also like you said, stocks get added and deleted from the index all the time. This information is usually telegraphed so the market can absorb the changes without any real changes in prices by market makers. Inefficiencies do exist but for the most part are efficient in my opinion. Any inefficiencies quickly get arbitraged.
Very good point. In fact typically, after a stock was included in the SP500 index, it usually went up.
This is an article from an Australian financial newspaper: http://www.afr.com/business/banking...e-active-v-passive-investment-20170427-gvu39r Active vs passive investing: There may be a message in the very long-term picture. Back in 2007, billionaire US investor Warren Buffett famously bet $1 million that a low-cost index fund would outperform a handpicked basket of expensive hedge funds over a period of 10 years. Although the wager doesn't officially end for another eight months, Buffett says there's "no doubt" he'll win. After all, the bundle of hedge funds had compound annual returns of 2.2 per cent in the nine years through to the end of 2016, well below the 7.1 per cent for the index fund. Even worse, the billionaire estimated that about 60 per cent of the gains that the hedge funds produced during the nine years were eaten up by management fees. "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients," Buffett sniffed in his latest annual letter to shareholders. "Both large and small investors should stick with low-cost index funds." Australian investors, it seems, aren't waiting to see the final result of Buffett's bet. Already, they're shifting more of their precious superannuation savings out of funds run by star stock-pickers, and into less glamorous index funds. Alex Dunnin, executive director of research at financial services information group, Rainmaker, says that around 12 per cent of all funds under management in Australia were invested in index funds a decade ago. Now it is almost double that amount, with more than 20 per cent (in excess of $400 billion) invested in funds that track an index, such as the ASX 100, or the ASX 300. What's more, Dunnin says, "if you look at the funds managers' performance, it looks like a further 20 to 30 per cent is in closet index funds – where the fund manager is pretty much hugging the index. "So it's not too far-fetched to say that around 50 per cent – or $1 trillion – of Australia's superannuation savings is following an index, whether explicitly or otherwise. And the other $1 trillion that is being actively managed is under threat." Dunnin says that the relentless comparison with index funds creates a huge dilemma for many of the country's active funds managers – those who pride themselves on their superior research and analysis, and their ability to discover "bargain" stocks investments which deliver superior returns. "Some can beat the index, but it's hard to do it all the time," he says. "And even the best ones go through patches where they underperform." It wasn't supposed to be this way. For years, many in the industry believed there were two reasons why high-quality active fund managers would consistently outperform the overall market. As Shane Oliver, head of investment strategy at AMP Capital, points out, the first has to do with the peculiar structure of the local share market. "The Australian market is dominated by two sectors – banks and resources. And therefore it should be possible for fund managers to obtain value by betting against, or in favour of, these sectors when they reach extreme valuations." The other reason is "there are fewer analysts, fund managers and stock pickers poring over the Australian market, compared with the United States. So it should theoretically be easier for managers to add value, because it's a less efficient market." These theories, however, are being sorely tested by reality. According to the investment research group, Morningstar, actively managed Australian equity funds that invest primarily in large cap stocks delivered a median return of 16.84 per cent in the year to March 2017, significantly below the median 18.67 per cent return from their passively-managed peers. Over a five-year period, however, the two investment styles achieved virtually identical results, and over 10 years, the median active fund managers delivered a slightly better performance. As Oliver observes, "it hasn't proved to be the case that active managers add value over the last year or so, according to the surveys. Although maybe this is just an aberration, as active managers have beaten the index on average on a longer-term basis." This huge shift of funds into passive indexed funds, however, is not without its risks. "The best example was the dotcom boom of the late 1990s" Oliver says. "At that stage, it paid off for investors to be in passive index funds because a lot of active managers believed that the market – and particularly tech stocks – was overvalued, and that meant they missed out on the full extent of the rally. "But all that went into reverse when the tech bubble burst. And it illustrated the danger of passive investing – that you can end up with a maximum exposure to an outperforming sector or stock just at the wrong time." As the tech-heavy Nasdaq powered through the 6000 level this week, some high profile investors warned that we are witnessing a replay of the dotcom boom of the late 1990s when investors were gripped with a similar fervour for technology stocks. That was before a sudden sell-off saw the Nasdaq plunge for than 30 per cent in 10 weeks from its peak on March 10, 2000. It took until March 2015 for the Nasdaq to regain the 5000 level. Is it possible that the latest rally in tech stocks is a re-run of the 1990s tech bubble? "It could be," Oliver says. "There's a lot of money pouring into ETF [exchange traded funds] passive funds. "What happens is that when a sector starts surging to the point that it becomes overvalued and extended on traditional measures, active funds start to under-weight it which causes them to under-perform relative to passive funds. So people start switching money out of active funds into passive funds." In turn, he says, this "reinforces the upward pressure on the outperforming sector, because indexes tend to have a bigger exposure to it. But it also exacerbates the under-performance of the actively managed funds, which causes even more people to switch." "So there's a spiral on the way up, until something causes it to break. And then it can unwind very quickly – as we saw back in 2000." Meanwhile, active fund managers are not only suffering the indignity of having their performance compared unfavourably with passive funds – they are also watching as their fees are slashed. "In private conversations with fund managers, they say there's a brutal obsession with lowering fees, and that if they don't lower fees, they're road-kill," says Dunnin. "It's got to the stage where some fund managers are wondering whether they should reject certain mandates because the fees are simply too low." As Dunnin explains, "the global financial crisis made people really cynical, because most highly paid investment professionals still suffered losses. So that triggered much more emphasis on fees and margins, as well as encouraging a shift to index investing. "But the risk is that we get to a stage where these products are not simply replicating the market, they've become the market. And at that point, there's a risk it could implode on itself." Oliver agrees that the growing importance of indexed funds could trigger greater market volatility. "The danger from an economic point of view is that you end up with a lot fewer analysts examining whether companies are doing the right thing by their shareholders, and trying to work out whether they're under-valued or over-valued," he says. "The risk is if everyone gets their managed market exposure through index funds, we'll end up with a far more volatile, less rational market where certain stocks and sectors get pushed to extremes, and where the share market does not perform its role in allocating scarce capital around the economy as well as it should."
themickey, Very good article. Let's think about it for a moment: 1. If today all the people invested in the US market are forced to convert to 100% index and there is only one index, the total market index. Tomorrow, any new money going in will also be indexed. The market can only go up by (new $)/(total $ in market index) and the relative positions/values of the stocks will not change since no one is buying more of one vs the others. So, in the short term, there is no market to speak of, everything go lock-step. The only thing affecting the market will be $ in vs $ out. 2. What about longer term? Longer term, companies grow at different rates and some go out of business. If we are only allowed to buy the index, do we care if the composition changes? The only thing affecting the index will again be $ in vs $ out? 3. In this scenario, winners are savers and losers are spenders as no one can game the system and profit. Am I making any sense?