TL;DR In my opinion, yes, still a good investment, if only because the alternative is not great
I think there’s several things to tease out:
1/ What do we mean by “Index Funds”? Are we talking about the platonic global cap-weighted fund which owns the entire investible universe? Are we talking about country specific cap-weighted funds? Sector specific? Cap-weighted but only the biggest n (S&P500, etc)? Cap-weighted, but also only if they meet certain governance / financial standards?
I find it quite hard to find fault with the platonic ideal of an index fund (although I will attempt to talk latter a little about some issues with it). Unfortunately, it’s pretty much impossible to create for any number of reasons.
There are definitely potential issues with individual indices.
a/ Index inclusion—it’s clear that being added / removed from the index can have massive impact on a company’s valuation. Recent examples include Tesla and [these guys front running index inclusion](https://www.sec.gov/news/press-release/2020-217)
b/ Governance—as more and more of stocks are owned by non-voting, passive owners it’s easier for management to get away with shadier dealings
d/ Missing the “good” investments—if assets revalue when they join an index, you are definitely missing out if all you are doing is buying the index. (At which point the assets will already have revalued). I think there is a similar phenomenon here related to where stocks are listed. The same stock can trade at vastly different valuations based on the stock market which its listed on. (Not at the same time, I mean here re-listing can be a big catalyst for stock price growth).
2/ What if index funds are overvalued in general?
”if index funds were overvalued, the active traders should make a killing on that inefficiency”
I don’t think this is quite right. If our platonic index funds are overvalued then the entire market is overvalued and there’s not really anything you can do about that as an active trader. (Except perhaps bet that it’s going to go down, and that’s a very tough bet to make). If you think that individual index funds are overvalued, that’s still a tough trade, since you have to wait for company cash flows to prove you right, and you might be waiting a long time / find yourself squeezed out by weight of money long before then.
3/ What are our alternatives?
Perhaps this is a lack of imagination on my part, but I see roughly 7 areas where you can “invest” your capital. (Separate from “using capital as collateral for running a trading strategy”).
There’s a case (I think best made by Mike Green) which suggests the world is divided into “Cash” and “Non-Cash” (which we can proxy with equities and bonds) and that the use of index funds is causing the amount of cash held in the world to decline which causes non-cash assets to revalue higher and higher (especially when valued in cash terms). I don’t think this story is completely true (I don’t think all buyers of index funds are entirely price insensitive) but I think it has enough merit which is worth thinking about.
My general view is from an asset allocation point of view there is very little to encourage bonds, commodities, precious metals and crypto. (Safe) bonds have negative real yields. Hoarding commodities seems to have little utility so why should it have positive returns. Gold / Precious metals / Crypto only seems to derive it’s value from some sort of Keynesian beauty contest which I feel I have no edge in so I tend to steer clear. That said, I still think it’s worthwhile holding some of all of them if only to benefit from their lack of correlation, store of value properties which enable you to rebalance.
So we’re left with Equities and Real Estate. I’m going to dump real estate into equities on the grounds that you can hold real estate via REITs, but I think RE has properties much more similar to inflation linked bonds than companies.
The next question, now we’ve established our asset allocation, is “How do I own my equities?”. Again (lack of imagination on my part) I see roughly two choices here: Own index funds. Buy individual stocks.
Owning index funds has a lot to recommend it—cheap, easy to do, getting information from the whole market etc
Buying individual stocks has a lot of problems—how do you find them? how do you value them? what makes you think you’re better at it than the market at large?
My general advice to people who can’t solve those problems is “Own Index Funds”.
Some other things which I didn’t mention here, but really are somewhat important stories
1/ Active trading (as opposed to active investing). Market making, stat arb, etc
2/ The rise of private investments. There’s a decent case that the best listed companies get taken private, leaving the public markets with only the very largest companies which no-one can take private, and the companies which no private equity firms want to take public
3/ Semi-active investing / factor investing. I find it quite hard to ignore the evidence that there are factors which outperform broad market indices (Momentum, Value, Large Cap, Low Vol, etc). Should you misweight your investment away from cap-weights to capture some of this additional value?
TL;DR; TL;DR TINA
TL;DR In my opinion, yes, still a good investment, if only because the alternative is not great
I think there’s several things to tease out:
1/ What do we mean by “Index Funds”? Are we talking about the platonic global cap-weighted fund which owns the entire investible universe? Are we talking about country specific cap-weighted funds? Sector specific? Cap-weighted but only the biggest n (S&P500, etc)? Cap-weighted, but also only if they meet certain governance / financial standards?
I find it quite hard to find fault with the platonic ideal of an index fund (although I will attempt to talk latter a little about some issues with it). Unfortunately, it’s pretty much impossible to create for any number of reasons.
There are definitely potential issues with individual indices.
a/ Index inclusion—it’s clear that being added / removed from the index can have massive impact on a company’s valuation. Recent examples include Tesla and [these guys front running index inclusion](https://www.sec.gov/news/press-release/2020-217)
b/ Governance—as more and more of stocks are owned by non-voting, passive owners it’s easier for management to get away with shadier dealings
c/ Anti-competitiveness - [Matt Levine has written extensively about this idea](https://www.bloomberg.com/opinion/articles/2020-01-09/people-are-worried-about-index-funds) I don’t take it too seriously, and I don’t think it harms investors as much as the broader market
d/ Missing the “good” investments—if assets revalue when they join an index, you are definitely missing out if all you are doing is buying the index. (At which point the assets will already have revalued). I think there is a similar phenomenon here related to where stocks are listed. The same stock can trade at vastly different valuations based on the stock market which its listed on. (Not at the same time, I mean here re-listing can be a big catalyst for stock price growth).
2/ What if index funds are overvalued in general?
”if index funds were overvalued, the active traders should make a killing on that inefficiency”
I don’t think this is quite right. If our platonic index funds are overvalued then the entire market is overvalued and there’s not really anything you can do about that as an active trader. (Except perhaps bet that it’s going to go down, and that’s a very tough bet to make). If you think that individual index funds are overvalued, that’s still a tough trade, since you have to wait for company cash flows to prove you right, and you might be waiting a long time / find yourself squeezed out by weight of money long before then.
3/ What are our alternatives?
Perhaps this is a lack of imagination on my part, but I see roughly 7 areas where you can “invest” your capital. (Separate from “using capital as collateral for running a trading strategy”).
a/ Cash
b/ Equities
c/ Real Estate
d/ Bonds
e/ Commodities
f/ Precious metals
g/ Cryptocurrencies
There’s a case (I think best made by Mike Green) which suggests the world is divided into “Cash” and “Non-Cash” (which we can proxy with equities and bonds) and that the use of index funds is causing the amount of cash held in the world to decline which causes non-cash assets to revalue higher and higher (especially when valued in cash terms). I don’t think this story is completely true (I don’t think all buyers of index funds are entirely price insensitive) but I think it has enough merit which is worth thinking about.
My general view is from an asset allocation point of view there is very little to encourage bonds, commodities, precious metals and crypto. (Safe) bonds have negative real yields. Hoarding commodities seems to have little utility so why should it have positive returns. Gold / Precious metals / Crypto only seems to derive it’s value from some sort of Keynesian beauty contest which I feel I have no edge in so I tend to steer clear. That said, I still think it’s worthwhile holding some of all of them if only to benefit from their lack of correlation, store of value properties which enable you to rebalance.
So we’re left with Equities and Real Estate. I’m going to dump real estate into equities on the grounds that you can hold real estate via REITs, but I think RE has properties much more similar to inflation linked bonds than companies.
The next question, now we’ve established our asset allocation, is “How do I own my equities?”. Again (lack of imagination on my part) I see roughly two choices here: Own index funds. Buy individual stocks.
Owning index funds has a lot to recommend it—cheap, easy to do, getting information from the whole market etc
Buying individual stocks has a lot of problems—how do you find them? how do you value them? what makes you think you’re better at it than the market at large?
My general advice to people who can’t solve those problems is “Own Index Funds”.
Some other things which I didn’t mention here, but really are somewhat important stories
1/ Active trading (as opposed to active investing). Market making, stat arb, etc
2/ The rise of private investments. There’s a decent case that the best listed companies get taken private, leaving the public markets with only the very largest companies which no-one can take private, and the companies which no private equity firms want to take public
3/ Semi-active investing / factor investing. I find it quite hard to ignore the evidence that there are factors which outperform broad market indices (Momentum, Value, Large Cap, Low Vol, etc). Should you misweight your investment away from cap-weights to capture some of this additional value?