Back in August of 2017, I wrote some random thoughts about investing in index funds (which were largely ignored as far as I can tell):
I wouldn’t exactly call this the end of index funds, but there are some interesting implications here.
I’ve no idea whether index fund managers can influence markets like this. They tend to be passive, not wanting to “rock the boat.” The article states that fund managers often side with activist investors but this is completely counterintuitive to a passive strategy.
Passive investors would side with management or resist voting at all.
If they are voting with activists, they are not passively investing anymore.
There is also the issue of supply/demand in the markets.
I read something recently, that was published years ago, about supply/demand dynamics in passive investments like index funds.
Basically when you have more supply than demand, the price for a product can be very cheap. We understand this as a “buyer’s market.” But when demand is higher than supply, the reverse happens.
A few years ago, we had a bumper crop of sweet potatoes here in NC. Stores were practically giving these things away. After the supply was gone, prices rose again.
In the case of the economy, the “supply” is not just the availability of stock certificates or stock shares but what the stock represents: ownership in a company and, more fundamentally, a share of the profits of that company.
As an investor, you want a share of total supply, of total profits.
Index fund investors kinda sorta ignore the idea that their passive strategy can be impacted by supply/demand dynamics in the same way that an active stock picking strategy can.
Passive investors ignore company valuations and profits, etc., deeming them irrelevant or an unimportant consideration when choosing their investments, instead opting for broad diversification which they hope will eliminate or at least greatly minimize the need to make value judgments about a company.
That’s not seen as a bug, but rather a feature, of this approach.
In effect, diversification is supposed to eliminate the need to think about what they are investing in.
They hope that some of their investments in the index fund do well while also acknowledging that some investments won’t do well… but they don’t know why and they aren’t concerned with the “why”.
What they hope is the good investments will balance out the bad and order will be restored to The Force.
For this to work out as planned, an index fund investor has to buy a bunch of bad investments along with the good ones… and they don’t know which is which. And this is OK, according to the intellectual leaders in the index fund movement.
When everything is bundled into a mutual fund, what changes over time is the Net Asset Value (NAV) of the fund. When you have a bunch of people excited about this indexing idea, they pile into the funds. And of course some index funds get to be more popular than others, attracting more money, which (eventually) helps the NAV of the fund.
Of course there are legitimate gains being made in the market but there are also natural increases in NAV due to buyers bidding up the price, just like any other product.
What this article proposed was these investors are effectively bidding up the price on some of the underlying stocks that are, in reality, bad investments.
To some extent, they might also bid up the price on good investments too.
What happens when the bidding causes these things to be overvalued? In other words what happens when the value is not justified by actually-existing profits or when profit targets are unrealistic?
Or what happens when investors stop putting so much money into these things?
Good question.
No one really seems to think this can happen. In fact, it’s nearly impossible to find any criticisms about index fund investing.
But, why not?
Are index funds immune to the economic laws of supply and demand?
One of the things indexing has done has lulled folks into thinking theres no risk (or very little risk) in the stock market. Another thing index investing has done is taught people that making value judgments (about stocks, specifically) isn’t necessary and, more… that it’s undesirable.
Not good.
This is a strategy that often bites people in the butt. It happened earlier this year, throwing people off track for their long-term financial plan. The odds are it will happen again.
