Index Fund Bubble?

[Craig]

I will preface this by saying I know just enough about personal finance to raise the question, but not much else. Like many in the FIRE space, I max out my tax-deferred space every year and contribute some to a taxable account, all invested in a 3-fund portfolio.

Indexing has seemingly become the new trend in investing, and rightfully so. It's easy to grasp, diversified, and can be largely automated. The other day I was getting a hair cut, and my barber started telling me about his spread between VGTSX and VTSMX. ”You know it's time to sell when the shoeshine boys give you stock tips" is the first thing I thought...

If an increasing amount of people are funneling an increasing amount of money into these funds, doesn't that potentially create a bubble out of the underlying equities that create the fund, which in turn creates a bubble out of the entire market since the funds are broadly exposed? What are the arguments for/against this? And if an "index fund bubble" does exist, what are the potential ramifications for the market vs. a sector-specific bubble?

 

[volker]

It's good that people stop putting money in individual stocks but index funds. I don't think that there will ever be a index fund bubble. It's more about economical and stock bubbles.

Overvalued stocks are somewhat a problem. They bring risk and require adjustments in the market. That is nothing new and happens every few years. But how do you know when the bubble will burst? Some people thought that the market was ready for a bigger adjustment when the Russell 3000 hit 1200 (S&P500 was 2000). Didn't happen.

Since you can't time and predict the market, what do you want to do? Let's say you would have moved out of the market in 2014 because you thought it should burst you would have lost all the dividends. If you have recurring payments you would have lost the few time the market dropped shortly. And you would have also lost since the interest rate is really low.

The general advice is to not invest if you need the money in the next years (or next 10-20 years). Just ignore the bubbles and re-balance on a recurring basis. I would be happy about a bigger drop since then I can buy stocks (via funds) much cheaper and it will raise over time again. And even if the stocks are down I still get dividends.

I read recently about someone who said that if the market drops x% he will put 50% of his bonds in index funds. If the market drops another x% he will put the rest in (having no bonds). That makes totally sense to me if you assume that the market will always go up again (and you can wait 20yrs).

Regarding the question of overvalued broad market vs. a branch (dot-com bubble): it doesn't matter to me. In 2000 the dot-com bubble bursted and all stocks where going down (not just the ones from the dot-com invested companies). Same happened a few years later when the housing market crashed: everything got down because everyone paniced.

Just don't panic! And google, there are lot of good articles out there explaining in detail why you should keep your stocks when the market goes downhill. Just set yourself a fixed schedule when to rebalance and stick with it. And be happy when everyone else panics. Their panics are your benefit since you can buy then the funds for much less money.

 

[Craig]

It's good that people stop putting money in individual stocks but index funds. I don't think that there will ever be a index fund bubble. It's more about economical and stock bubbles.

Overvalued stocks are somewhat a problem. They bring risk and require adjustments in the market. That is nothing new and happens every few years. But how do you know when the bubble will burst? Some people thought that the market was ready for a bigger adjustment when the Russell 3000 hit 1200 (S&P500 was 2000). Didn't happen.

Since you can't time and predict the market, what do you want to do? Let's say you would have moved out of the market in 2014 because you thought it should burst you would have lost all the dividends. If you have recurring payments you would have lost the few time the market dropped shortly. And you would have also lost since the interest rate is really low.

The general advice is to not invest if you need the money in the next years (or next 10-20 years). Just ignore the bubbles and re-balance on a recurring basis. I would be happy about a bigger drop since then I can buy stocks (via funds) much cheaper and it will raise over time again. And even if the stocks are down I still get dividends.

I read recently about someone who said that if the market drops x% he will put 50% of his bonds in index funds. If the market drops another x% he will put the rest in (having no bonds). That makes totally sense to me if you assume that the market will always go up again (and you can wait 20yrs).

Regarding the question of overvalued broad market vs. a branch (dot-com bubble): it doesn't matter to me. In 2000 the dot-com bubble bursted and all stocks where going down (not just the ones from the dot-com invested companies). Same happened a few years later when the housing market crashed: everything got down because everyone paniced.

Just don't panic! And google, there are lot of good articles out there explaining in detail why you should keep your stocks when the market goes downhill. Just set yourself a fixed schedule when to rebalance and stick with it. And be happy when everyone else panics. Their panics are your benefit since you can buy then the funds for much less money.

I'm not asking this question from a "what should I do" perspective, more so from that of the fundamental economics of markets and market-based products (index funds in this case). My money is going where my financial plan says it's going. But, for example, if Wal-Mart is one of the stocks in the index fund, and a billion new investors invest a trillion new dollars in that fund over a short period of time, then Wal-Mart's stock price balloons in response to the enormous rise of investment in the index fund, despite nothing changing in the fundamentals of that individual stock, right? If so, isn't that a problem?

 

[volker]

But, for example, if Wal-Mart is one of the stocks in the index fund, and a billion new investors invest a trillion new dollars in that fund over a short period of time, then Wal-Mart's stock price balloons in response to the enormous rise of investment in the index fund, despite nothing changing in the fundamentals of that individual stock, right? If so, isn't that a problem?

The balloon is, depending on the fund, spread over hundreds or thousand of companies. As result every companies price balloons. Yes, the higher demand leads to higher prices. But it's always a cycle between everyone is going in or out. I don't see a problem with this. I would assume that individual stock purchases or sales have a much higher impact, it changes the price in a more unbalanced way. I would assume that can lead more to a sector-bubble. Well, there are also sector based index funds which I ignore here.

 

[ENOTTY]

Stock index funds should not be the only indexes you invest in. Typical asset allocations include a healthy allocation to bonds, which should do well when stocks are doing poorly. So if there is a bubble in stocks and it pops, your bond allocation should help you out. You also should consider diversifying geographically. Not every country's economies do well all at the same time.

 

[lpaca]

If an increasing amount of people are funneling an increasing amount of money into these funds, doesn't that potentially create a bubble out of the underlying equities that create the fund, which in turn creates a bubble out of the entire market since the funds are broadly exposed? What are the arguments for/against this? And if an "index fund bubble" does exist, what are the potential ramifications for the market vs. a sector-specific bubble?

I think one way to look at this is: what is the inflow of money into stock index funds coming from? If it's primarily because people are realizing actively managed funds have consistently underperformed the index funds (net fees), then it will be a wash. Money that would have been invested in companies through mutual funds is still invested in those companies via index funds, just with lower fees. Or if the same money would have been spent picking individual stocks, it would also be roughy a wash. If the inflows are in place of bonds, that might not be a bad thing either. I think in most cases, the index fund increase is probably primarily in place of an actively managed fund or picking individual stocks, which is a great thing. All of those are equally susceptible to a stock market bubble and one isn't more likely to "cause" a bubble.

 

[credipig]

Efficient market theory states that all stocks are priced at fair value. The theory is based upon the assumption that all investors have access the same info regarding stocks, and they invest accordingly. Of course there can always be temporary variations, but stocks always return to their fair value.

If the valuations of companies comprising an index fund became too pricey, investors would sell or short those stocks, bringing their valuations back to where they belong.

 

[ENOTTY]

Temporary variations would imply that the market is not completely efficient

 

[Matt]

Efficient market theory states that all stocks are priced at fair value. The theory is based upon the assumption that all investors have access the same info regarding stocks, and they invest accordingly. Of course there can always be temporary variations, but stocks always return to their fair value.

If the valuations of companies comprising an index fund became too pricey, investors would sell or short those stocks, bringing their valuations back to where they belong.

Let's remember that EMT is just a theory, and even then it is broken into 3 varying views of how believable it is. Also, we need to remember that not everyone can sell or short, some of the biggest players in the markets (Pension Funds for example) have set rules on return and what they can invest with.

Not that I think there is an Index Fund Bubble.

 

[PurpleSquirrel]

Index funds are the only vehicles for an average investor to invest in. I agree with your barber, in this case.
It could also imply we are nearing a peak in the stock markets.

 

[volker]

Index funds are the only vehicles for an average investor to invest in. I agree with your barber, in this case.
It could also imply we are nearing a peak in the stock markets.

What does the "advance" investor do in your opinion? Gamble on single stocks? Going into high fee funds? Invest in metal?

 

[PurpleSquirrel]

What does the "advance" investor do in your opinion? Gamble on single stocks? Going into high fee funds? Invest in metal?

Advanced investors usually have an edge / niche that they are able to dominate and understand that niche. I know of one guy, that has been trading gold stocks and his analysis is razor sharp. He understands the various players, understands complex CBOT weekly reports and can understand why things are happening or going to happen. He was the only person that forecast that gold would shoot up by 30-40% back in Jan 2016. Based on reports, he can tell if longs/shorts are piling up and if big commercials/speculators are hiding their positions. Has turned a $30K investment to $2.5 million.

Another advanced investor I know buy/sell options on dividend stocks. He is able to double the rate of return than just buying plain dividend stocks.

 

[volker]

Advanced investors usually have an edge / niche that they are able to dominate and understand that niche. I know of one guy, that has been trading gold stocks and his analysis is razor sharp. He understands the various players, understands complex CBOT weekly reports and can understand why things are happening or going to happen. He was the only person that forecast that gold would shoot up by 30-40% back in Jan 2016. Based on reports, he can tell if longs/shorts are piling up and if big commercials/speculators are hiding their positions. Has turned a $30K investment to $2.5 million.

Another advanced investor I know buy/sell options on dividend stocks. He is able to double the rate of return than just buying plain dividend stocks.

That sounds like a full time job and not something for the Jones. And even most people working in investment banking won't be able to beat the broad market long term.

 

[VanillaSmack]

He was the only person that forecast that gold would shoot up by 30-40% back in Jan 2016. Based on reports, he can tell if longs/shorts are piling up and if big commercials/speculators are hiding their positions. Has turned a $30K investment to $2.5 million.

Not to knock this guy you know, maybe he is an incredible genius, but also consider that sometimes people are just lucky. You don't hear about the thousands of other investors who lost their $30K betting on some other movement in gold or whatever that didn't pan out.

Interesting essay I came across a while ago and has stuck with me ever since: "Randomness as Meaning." Quote that is particularly applicable to index fund investing:

...how do stockbrokers stay in business? That's easy — they lie. Instead of confessing that a typical investor will come out behind the market average, they correctly point out that some investors become millionaires. Every stockbroker has a few stories like the best outcome in this simulation — the lucky investor who started out with $10,000 and ended up with $4,638,235.88. But this truth cannot erase a more important truth — that on average, a buy & hold investor will do better than an active trader.

 

[volker]

Post deleted. It was actually described much more down the one linked article.

 

[imMia430]

I believe it is time to get more conservative with your portfolio since the market has rallied up for the last 8 years without much internal improvements. However, crude and gold seem to have picked up from their previous lows.

 

[redbirdsj]

As others have stated, EMT posits that the value of the underlying equities that comprise index funds will be held in check by market forces (e.g., others shorting those positions). There are plenty of hedge funds attempting to arb this effect and no shortage of funding of those by America's rich who refuse to believe in the premise of index funds.

There are some interesting arguments about the rise of index funds concentrating too much power in the hands of fund managers which hold the proxies of underlying shares of the index and the negative effect on corporate governance. For example, the fund managers may be too cushy with management because they are also courting them and their HR departments for their 401k/qualified plan business. That makes them less likely to vote against management when it may be in the best interest of their stakeholders, the owners of the fund.

 

[volker]

There are some interesting arguments about the rise of index funds concentrating too much power in the hands of fund managers which hold the proxies of underlying shares of the index and the negative effect on corporate governance. For example, the fund managers may be too cushy with management because they are also courting them and their HR departments for their 401k/qualified plan business. That makes them less likely to vote against management when it may be in the best interest of their stakeholders, the owners of the fund.

How would this work? As index fund you are bound to follow an index as close as possible. You can't go to a company X and treat them to sell all the shares of X.

I am wondering if this would be even a breach of contract if you would get too far off the index.

 

[redbirdsj]

How would this work? As index fund you are bound to follow an index as close as possible. You can't go to a company X and treat them to sell all the shares of X.

I am wondering if this would be even a breach of contract if you would get too far off the index.

The issue is how the funds vote the shares for which they hold the proxies. Fund managers have a conflict of interest because on the one hand they are bound to vote in the best interest of the fundholders but on the other hand they want to win business from the corporations owned by the fund for their qualified plan provider and advisory business.

 

[Cliffbar]

Not to knock this guy you know, maybe he is an incredible genius, but also consider that sometimes people are just lucky. You don't hear about the thousands of other investors who lost their $30K betting on some other movement in gold or whatever that didn't pan out.

Interesting essay I came across a while ago and has stuck with me ever since: "Randomness as Meaning." Quote that is particularly applicable to index fund investing:

Moreover, if you look at returns of active large-cap funds over a five year period and pick out the top 25% of performers. Randomness would predict that, over the next five year period, 1/4 of those funds would be in the top 25% again. So if skill drives performance, then you'd expect far more than 1/4 to remain in the top 25%. However, it turns out that only ~6% of the top funds remain the top quartile.