I've heard that when you leave direct indexing you end up with all the individual stocks in your new portfolio, or you have to sell them and eat the capital gains tax. Was that your experience?
Yes, but this does not diminish the value of the companies in the long term. Remember that index funds are an investment vehicle for decades, not months.
Do you capture the effects of a ticker symbol delisting from the index? Trivial for a single stock of course, but looking across a portfolio, then the effects from delisting from an index, new listings into the index, stock splits, and M&A inevitably becomes a thing.
1) That's not how index funds work: they attempt to track a target market index. At most, it happens indirectly: get your company into the major indices by a short-sighted depletion of capital, and you can get some level of lift from index funds blindly purchasing your stock (though IIRC it's not a huge effect).
2) You can effectively remove certain companies from an index using derivatives in addition to the index. Alternatively, look into direct indexing, where you attempt to track an index by directly owning an appropriately weighted basket of stocks, though it tends to be more complicated, have greater tracking errors, and have higher fees.
You dodge the arbitrage of stocks getting in and out of the index but you miss the virtue on using an index, which is that the index rules are not a horrible investment strategy: buy the stocks that are on the rise, sell when stocks are on the way down.
But total markets will still have other downsides, like all the stocks become completely correlated if enough people are only making investment decisions on the total market instead of individual stocks, and prices become less meaningful.
I don't think that makes a difference. If I am understanding the mechanics of equity indices correctly...
The return of the index can be replicated even when stocks get delisted (an investor sells the stock that gets delisted.) When a new stock is added to the index, an investor buys this new stock.
I think the implication is that the retail index investors will end up doing worse.
One thought experiment is if being part of an index confers additional perceived value, the addition or removal from it index is an Arbitrage opportunity.
Imagine trading against someone who will reliably pay a premium for an index of "top 10 stocks". Price will spike for a stock that goes from #11 to 10, and drop for every stock that goes from 10 to 11.
Index investors will overpay for a newly listed stock and that money will go to an active investor that held it before the listing. Inversely, index investors will lose money whenever a stock is removed from the index.
There is an equilibrium point between indexed and non-indexed portfolios in terms of optimizing expected returns. Capital will move to whatever portfolio type is giving the best returns if too much of the market is composed of one or the other. More money moving into indexing makes it easier to outperform the index because there are fewer investors competing to profit from mis-priced equities, making those positions cheaper to acquire. Anecdotally, I find it easier to outperform the indexes today than it was fifteen years ago.
Even if the entire market is indexing, there are still fundamental mechanisms that will keep it responsive. Markets are indexed in many ways depending on what aspect of the market the indexes are trying to capture, and these different indexes weight and value the underlying stocks differently, with some indexes outperforming others which will drive allocation of capital to different indexes. And at the extremes, over-valuation is addressed by bankruptcy and under-valuation is addressed by taking a company private, removing companies from the market entirely.
I'd appreciate if you could expand on that, because I share the same concern as GP. It seems to me that the index fund has to sell a lousy company at a low price (since it's being delisted) and buy a strong one that's being included in the index. Whereas the index, being just a number, can magically perform the swap without taking a hit.
When you buy an index fund, your investment gets weighted across many companies.
If some are delisted, the fund loses the money allocated to them, but not its whole portfolio. Then new companies are added to the index, and the fund's remaining assets get re-allocated to match the rules of the fund's underlying index.
I'm not the OP or the grandparent post, but I wonder what happens if a significant portion of the market starts indexing? My gut is that there are strong incentives against that: as more people start indexing, the gains from not indexing become more diverse.
I don't see how this reduces returns for indexers in particular. Investing in an index means you get the market average. This may result in lower returns for the total market and thus also for indexers but for some active investors to overperform thanks to this some other active investors will need to underperform. Winning that directional bet requires someone else to take the other side of the bet and lose. Total market returns are zero sum.
That's not how it works, the return of the index is the actual return of the included stocks while they are in the index. There will be winners and losers, but the return is actually what you get.
Wouldn't the exiting and entering of companies have a negative effect on the index holder over time (as they are selling the exiting companies when they are valued low and buying the entering companies when they are valued high)?
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