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URL:  http://boards.fool.com/yes-many-of-the-major-indexes-are-cap-weighted-22893929.aspx

Subject:  Re: Percentage of Market in Index Funds Date:  8/15/2005  10:58 PM
Author:  Viznut Number:  47243 of 76418

Yes, many of the major indexes are cap-weighted. However, I don't see any way that could cause a bubble.

Let me take a much simplified example. This should demonstrate my point, and may also point out my misconception to you, if one exists.

Suppose a market-cap weighted index tracks two stocks A & B, 50%/50% ($20 million of each = $40 million total). Now suppose Warren Buffet sells a bunch of stock A with good cause causing the price of stock A to drop 50%. Company A's market cap just dropped 50%, lowering the paper value of the overall index's assets 25% ($10 million dollars, new total $30 million). If the index doesn't immediately recomputed the weightings, it's going to try and sell $5 million of stock B and "purchase" $5 million of stock A (contrary to Buffet's good sense) to restore a 50/50 weighting, totally oblivious to the good reason that the investors might have exercised.

At first glance, it intuitively seems like index funds, if allowed to amass sufficient market share, are financially like big capacitors that soften the effect of other changes, tending to counteract the effect of investors making considered buy/sell decisions in the market. This would apparently tend to keep the market floating high when it really needs a downward adjustment (a bubble) or keep it hanging low when it is really due for a rise.

I use Morningstar Instant X-Ray for this

Thanks for the reply, and the link. I didn't find data that helps to answer the question what percentage of the market is tied up in indexing vs. non-indexing investments though. But I could have missed it.

Even so, the S&P 500 is doing something to satisfy concerns similar to yours.

Interesting -- thanks. If shares owned by index funds such as Vanguard are classified as stocks owned by "other publicly traded companies" in this language, it does seem that this might help subtract out the "indexing effect". Though with fewer shares under consideration, it may may make stocks more volatile and increase the influence of investors with large market share in a company. But that's probably better than having index funds make decisions based on the automated trades of other index funds.
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