Finding these somewhat obscure but nonetheless amazing academic studies is really your forte! I recall reading a piece years ago claiming that index funds are "free riders" on the work of active investors who do all the rigorous research and corporate governance legwork https://magazine.wharton.upenn.edu/digital/the-problem-with-index-investing/ , with the former only showing up much later when they become part of the index, thus turning them into "self-fulfilling prophecies" which are then slower to react to bad news because "everyone has to own them".
So i guess, this means that index investing is really the best for passive investors, as they are reinforcing the results of themselves. This also show that studies that tries to conclude anything from past data by itself, like the fama-french factors, aren´t really rigorous since investors behaviors and capital flows determine much of stocks returns and they are not stable through time. But if index investors stagnate, them should we see a reversal in trend and small-caps returning there edge?
You are making an important point. It reminds me of Cliff Asness latest piece where he argues that the rise of index investing and other factors have made markets LESS efficient. If he is right, it means that any kind of factor will have a harder time generating returns in the future because for almost all factors you need some kind of reversal to fundamental fair value or historic mean.
Cliffs piece is on my read list, but i got more curious to read it now that you metioned it! Particularly, i think that factor investing is prone to data mining and without causal analysis is a bit unreliable, even if there are true factors, since there is a zoo of factors, it´s difficult to determine what is true positive and what is a false positive. I also think that quant investing and the many different styles of investing that are growing because of it may make the market even more volatile and prone to extreme fluctuations, plus unpredictable, because of flows and data mining behavior, i´m going to read the piece to see if that´s he´s point as well or not.
Thank you for a very interesting article, as usual. Index funds are a perversity. I know that Warren Buffett likes them, but I think that is merely from the perspective of the uninitiated retail investor. Arguably, the main reason why capitalism is superior to socialism is that under capitalism markets, rather than politicians, do the allocation of resources. The main reason we have markets, indeed, is that they allocate resources by allowing market actors to bid according to what they think is the value of the different assets. By doing so, resources will end up where they will be most efficiently used. Until the arrival of index funds, that is. Since index funds don't do the crucial act of bidding according to their evaluation of stocks, they lack this fundamental and crucial characteristic of a market actor. Rather, they act like a ship without a captain. For this reason, index funds increase volatility. I'm not surprised that index funds have awkward effects. Now that they have reached 30% of the market, it gives me a vision of a cargo liner with one sole hatch where 30% of the cargo is floating around freely. Imagine what would happen if index funds owned 99% of the market and you sold 1000 Nvidia.
Finding these somewhat obscure but nonetheless amazing academic studies is really your forte! I recall reading a piece years ago claiming that index funds are "free riders" on the work of active investors who do all the rigorous research and corporate governance legwork https://magazine.wharton.upenn.edu/digital/the-problem-with-index-investing/ , with the former only showing up much later when they become part of the index, thus turning them into "self-fulfilling prophecies" which are then slower to react to bad news because "everyone has to own them".
So i guess, this means that index investing is really the best for passive investors, as they are reinforcing the results of themselves. This also show that studies that tries to conclude anything from past data by itself, like the fama-french factors, aren´t really rigorous since investors behaviors and capital flows determine much of stocks returns and they are not stable through time. But if index investors stagnate, them should we see a reversal in trend and small-caps returning there edge?
You are making an important point. It reminds me of Cliff Asness latest piece where he argues that the rise of index investing and other factors have made markets LESS efficient. If he is right, it means that any kind of factor will have a harder time generating returns in the future because for almost all factors you need some kind of reversal to fundamental fair value or historic mean.
Here is Cliffs piece: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4942046
Cliffs piece is on my read list, but i got more curious to read it now that you metioned it! Particularly, i think that factor investing is prone to data mining and without causal analysis is a bit unreliable, even if there are true factors, since there is a zoo of factors, it´s difficult to determine what is true positive and what is a false positive. I also think that quant investing and the many different styles of investing that are growing because of it may make the market even more volatile and prone to extreme fluctuations, plus unpredictable, because of flows and data mining behavior, i´m going to read the piece to see if that´s he´s point as well or not.
Thank you for a very interesting article, as usual. Index funds are a perversity. I know that Warren Buffett likes them, but I think that is merely from the perspective of the uninitiated retail investor. Arguably, the main reason why capitalism is superior to socialism is that under capitalism markets, rather than politicians, do the allocation of resources. The main reason we have markets, indeed, is that they allocate resources by allowing market actors to bid according to what they think is the value of the different assets. By doing so, resources will end up where they will be most efficiently used. Until the arrival of index funds, that is. Since index funds don't do the crucial act of bidding according to their evaluation of stocks, they lack this fundamental and crucial characteristic of a market actor. Rather, they act like a ship without a captain. For this reason, index funds increase volatility. I'm not surprised that index funds have awkward effects. Now that they have reached 30% of the market, it gives me a vision of a cargo liner with one sole hatch where 30% of the cargo is floating around freely. Imagine what would happen if index funds owned 99% of the market and you sold 1000 Nvidia.