Fund managers: it is even worse. Because customers will choose the fund with the best tack record, managers have an incentive to take high risks when the time to report comes near. If they win, they win big, if they lose, they lose just their bonus.
What i haven't understood yet is why index funds are supposed to be so great. At least if everybody would just buy undex funds, it wouldn't work. Also, who picks the stocks in the index? Why would index funds be better than just buying some random stocks?
Index funds are great, it works on the assumption that while the whole economy grows everybody who owns a share in an index wins. So it incentivizes people to grow the economy.
Only a few people can beat the market anyways and it's the people who can correctly assess the risks like insurance companies (that still win even if they lose), some VCs and people who are close enough to the companies that they just know that it's likely to be successful.
Could you elaborate on why that is the best thing for most people?
Because the evidence for "Mutual funds, in aggregate, underperform the market by precisely what they charge in fees; past performance of mutual funds does not predict future results; no more fund managers beat the market than would be suggested by random chance; capital flows into mutual funds are virtually invariably poorly timed to surge after they have made their gains, hurting fund performance" is incredible. It's, um, shoot, I need an analogy... you know how science suggests that cigarettes might not be a good thing health-wise? That conclusion is tentative next to "actively managed mutual funds are a poor investment vehicle."
Index funds are virtually structurally guaranteed to outperform actively managed funds for any given equivalent investment classes, because index funds also underperform the market by fees, but their fees are about 100 ~ 250 basis points lower. Over someone's working life, that turns into "Your retirement account is several times as large as your neighbor who used actively managed mutual funds."
Then you're not the customer for index funds. They are meant to be highly risk averse, and give decent gains to people who want safety of modest to low gains over high gains high risk.
Index funds are good. They are a way of saying "I don't know how best to allocate capital, i'll leave it to the professionals who do, and simply capture the market return for myself". Ideally, most money will be managed by index funds, and a small pool of extremely efficient money managers (some mix of quant and discretionary) will manage a comparatively small pool of capital that actually determines the prices of everything. There is nothing bad about this. This is the way all economic activities become more efficient.
An index fund typically performs much better over any meaningful timeframe because it has much lower fees.
But that's not the point here. The big money in investing isn't in beating the market, but charging fees, so fund managers only need to convince people to give them their money, they don't actually have to deliver results, provided they're working within the fund's stated goals.
The risk is because index funds don't do stock analysis (instead they buy and hold all stocks) they will invest in bad companies and prop their price up. Then when the bad company goes bankrupt (as everyone paying attention knows will happen) the index funds are left holding all the stock suddenly worth nothing.
Which is to say the traditional more expensive managed funds that actually pay attention to the fundamentals of the companies they invest in should see a comeback. While this style of fund is more expensive (because a human can only examine a few companies in a year in enough detail to decide if they are worth investing in - as a full time job you can maybe do 50) by investing only in companies that will do better than average they can beat the market (or shorting if you want to play companies that will do far worse than average). So far the low costs of index funds have made them a better investment despite them not investing in strong companies, but we should see the day where a managed fund can beat the index funds just because the index funds are leaving the advantages of analysis on the table.
You can argue [meaning this might or might not be correct] that historically managed funds have done worse than index funds because there are so many managers that anytime there is a slight deal someone jumps on it before the deal is large enough to pay for the costs of finding it. However if you don't jump on it someone else will and they make something on the deal while you make nothing. Thus as index funds take over there will be more and more deals for the managers to find, and managers can wait until they are large enough to be worth the price.
It will be interesting to see when/where the line is crossed.
The TL;DW is that in many different studies, index funds preform better in the very long term than almost any managed fund. Why pay some monkeys to manage your money when an even distribution over a bunch of common stocks does just as well?
I don't get the point of these. Index funds win most of the time, and when they don't index funds still win once you count the amount of time and effort needed to marginally beat them.
An index fund is a group of stocks. You buy them all together. That means that you're buying everything regardless if everything is worth buying. If tons of money gets put into the index funds, all the prices rise. This could mean that there are mispricings in the market that could eventually hurt the buyers of index funds.
Index funds are still regarded the best choice for a long term passive investor because of the amount of diversification.
Bit of a rookie here, but aren't the people who are giving the funds doing at least some due diligence researching how much better the returns will be than on index funds?
But it seems that most people don't really beat the index funds so the expected returns are essentially the same as index funds. Without higher returns why would you take higher risk?
Index funds, by simple math, return exactly the average of the market with less fees, so they are strictly better than the average managed money which returns the same with more fees:
And your ideas of picking 3 stocks + small cap is just that, an active bet that deviates from the market composition. Unless you've gone back on your conclusion that you're not Peter Lynch it's probably not much of a path.
The only risk of rising index fund usage is that the market will cease being efficient. The way I see it is if that starts happening strongly (and it will take a lot more indexing than currently exists) first the market will become more volatile because price discovery will be worse with less people making bets. Then at some point if there are too few active investors indexing will become less viable because it will be easier for active investors to "steal" money from indexers by trading ahead of them and using other advantages over someone that's just buying and holding. This will make the index fund deviate from the index itself and it becomes unusable.
I find these scenarios extremely unlikely because of the "Intelligent Investor" crowd you mention. There is indeed a premium paid to people that bring actual good information to the market. Buffett and others like him still make a lot of money, everyone else gets to ride along the efficient market they create. Buffett by the way recomends index funds.
I'd love a reasonable contrarian view on this though. Most I've seen are just fund managers trying to justify their unjustifiable fees that create no value.
People interested in this topic should really read "Trillions" by Wigglesworth. Maybe the most consequential book I read in 2022, as someone who read about a book a month, mostly nonfiction.
The book, first of all, does a good job of laying out the complete case for why index funds beat human managers, starting out by telling the story of an investor who made that very bet (literally), who ironically most people would put on the other side of that: Warren Buffett. Buffett bet a fund manager that an index fund would beat the best of any funds his opponent would select. A decade or so later, Buffett was proved right and declared the winner.
If even Warren Buffett is betting on index funds as beating active investors, why are most people so reluctant to?
But besides that... why are index funds - which you can also think of as 'fully automated/computerized investing' - so effective?
There's a few reasons, but a really simple explanation is: over time, a bunch of fund managers are just going to recapitulate the market, and the advantage computers have is, they can duplicate that functionality but their fees are zero (or 0.001% per year, whatever is the tiny amount it costs to run the servers). Human fees are not zero. Therefore, the computers win.
Another one is just that the whole market, diversified, ends up being the best hedge against... everything. Is Elon Musk a genius one day, and now getting pilloried as an idiot as the head of Twitter? If he's a big part of your portfolio, and you bought in a year ago, that really hurts. When you hold the whole market following impersonal computer rules, you are insulated from this.
And it turns out, when you look at the full impartial record of active investor picks, it's pretty poor really.
A final thought that book suggested to me: if you have over 10 million dollars, you probably can't beat what the market can do. Wave the white flag and throw it all in an index fund. The computers have won, and just as we acknowledge that with chess and Go (art's probably next), index funds are an extension of same.
What i haven't understood yet is why index funds are supposed to be so great. At least if everybody would just buy undex funds, it wouldn't work. Also, who picks the stocks in the index? Why would index funds be better than just buying some random stocks?
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