Indexing vs. rebalancing factor funds

masonic

aroominyork said:

Is passive investing the elephant in the room? It perpetuates momentum, and can growth be a rough proxy for momentum? Does that create a bubble which will periodically be pricked?

Could you explain your reasoning for this? 

Passive investing involves buying an proportional stake in each company with reference to a certain threshold size, then holding that number of shares perpetually while the company remains above the same size threshold. Ideally that size threshold is as low as possible. It does not involve buying more of companies that are growing faster, or selling those that are shrinking (other than to replace them with an alternative when they fall out of the index). This results in the largest positions being in the companies that have already grown very large, rather than the companies that are currently growing the fastest. On a valuation basis, different indexes can be very different, with some trading at earnings multiples far lower than others. To my mind, passive investing is just a reflection of the market and investor sentiment. But an index can never take on a "value" slant, because value is defined in terms of average valuations, with reference to the same index.

Bubbles certainly happen from time to time, but I wouldn't finger index investing as the cause, rather it is active investing that tends to distort the index to the extreme when everyone in clamouring to buy into certain fads selectively.

aroominyork

My starting point was that active fund managers, if they are not closet indexers, look for hidden gems across the index. Moving those monies into index funds adds larger amounts to the largest companies. Those monies will of course be added to companies in proportion to the market's pre-existing valuation of them. However, doesn't the reduced amount of active money which is responding to company news - imagine 95% of investor money sitting in index funds - mean the market does not reward good companies and punish bad ones, but just keeps pumping the largest amounts into the largest companies?

I had a search on Occam's site and found the following. I have not read it all but he takes the opposing view (and is more likely to be correct) that indexing creates market efficiency. https://occaminvesting.co.uk/is-passive-investing-causing-a-bubble/

JohnWinder

doesn't the reduced amount of active money which is responding to company news - imagine 95% of investor money sitting in index funds - mean the market does not reward good companies and punish bad ones, but just keeps pumping the largest amounts into the largest companies?’

Your scenario envisages no money going into or out of the market, which is fine; the other condition is money is added to or removed from the market.
I think it comes down to whether 5% of the market being actively traded is enough to make price discovery accurate. And wouldn’t 5% be enough? I can imagine 1% would be enough; it comes down to how many traders there are evaluating price information (the more the better I suppose) and share values, as much how much they are trading with each trade.
If Apple is held by index stocks at $10, and there are only two active investors on the planet, if one of them thinks the stock is worth $12 she’ll keep buying from the other who thinks it’s worth less than $12. Even if those two exchange only one Apple share which is 0.00etc1% of the whole market, the price will move to $12 I think. During the next microsecond, those two traders can exchange one share of Tesco, another 0.00etc1% of the market. Is that how it could work?

JohnWinder

Is passive investing the elephant in the room? It perpetuates momentum, and can growth be a rough proxy for momentum? Does that create a bubble which will periodically be pricked?

If there was only passive investing the only price movements would be money into or out of the market, affecting all stocks proportionately. No bubbles, no elephant.

aroominyork

JW, I've no idea how the Apple/Tesco scenario plays out, but your point of only a few active traders being needed to set accurate prices is interesting. I've no idea what the answer is, but surely it contradicts your second post which suggests things would be hunky dory with no-one setting prices. You would then have large companies attracting most new money irrespective of their performance and prospects and small companies remaining cheap even if they grow; surely they would create a bubble that would need bursting.

JohnWinder

Yes, true. Humour without emojis fails again. The 'all passive' scenario is fantasy land, and defies any coherent analysis by me.

aroominyork

Emoji schmemoji. Anyway, I guess it comes down to how market efficiency is affected by 5/20/50/95% of money being in index funds. I have a vague memory of Charlie Munger thinking index funds are storing up problems, but I'd have to check the source. (I'm on holiday - not sure if that means I spend more or less time looking at this stuff.)

JohnWinder

https://www.morningstar.com/portfolios/why-large-blend-is-better-than-value-plus-growth (July 18).

Perhaps the answer was staring us in the face before the question arose.

Linton

JohnWinder said:

https://www.morningstar.com/portfolios/why-large-blend-is-better-than-value-plus-growth (July 18).

Perhaps the answer was staring us in the face before the question arose.

I do not see that the title is justified by the results. Looking at the graph it would seem that suitable choice of start and end dates could result in different conclusions,

 An Interesting but very limited study. In particular..
 - it is based solely on relatively small variations around a US cap weighted index.
 - it only considers value vs growth
 - it focuses on very long term performance as the sole criterion for comparison.

A study based on global data that also included large vs small variation, variations in geographic allocation and deeper analysis of the results such as medium term standard deviation would be more interesting.

However the results are compatible with the hypothesis that over the long term all sufficiently diversified portfolios show the same performance. 

aroominyork

JohnWinder said:

https://www.morningstar.com/portfolios/why-large-blend-is-better-than-value-plus-growth (July 18).

Perhaps the answer was staring us in the face before the question arose.

Good hunting, JW! Can you confirm whether the growth and value indexes are representative of all companies and so meet in the middle (ie where they exhibit marginal growth or value characteristics) or are only those with characteristics above a certain level and therefore omit the companies in the middle?

PS to the question above. Typically the fewer holdings a fund has, the more tilted it is. For example in value ETFs, XDEV with about 400 holdings has a stronger value bias than PSRW with about 1150 holdings. For the Rekenthaler analysis described in this article, VIVAX has 343 holdings and VIGRX has 235 holdings. That makes me think the analysis looked at strong growth and strong value biases while a large part of the market - the centre ground - was excluded. It was not comparing like with like, which would have been done by dividing the full market into two halves of growth and value.