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Author: rkmacdonald Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75340  
Subject: Re: Percentage of Market in Index Funds Date: 8/14/2005 8:57 PM
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Author: Viznut | Date: 8/13/05 8:19 PM | Number: 47212
Does anyone know where to look to find out what percentage of US/int'l stocks and bonds are held by index funds?


I use Morningstar Instant X-Ray for this:

http://portfolio.morningstar.com/NewPort/Free/InstantXRayDEntry.aspx?runMode=MSTAR

I'm an indexing proponent, and my entire retirement portfolio save my current 401K is in index funds. But I'm a little concerned that down the road if a significant percentage of all market assets are tied up in index funds, that we're in for a hypersensitive market with fragile prices due to all the indexing people reacting to each other's laziness and not the business fundamentals.

Aren't most market indicies are based on market cap (share price * num shares -- i.e. what people "think" the business is worth) rather than some fundamental measure of the business (book value, cash flow, discounted future cash flow, etc.).


Yes, many of the major indexes are cap-weighted. However, I don't see any way that could cause a bubble. Take the S&P 500 Index. It covers about 96% of all the business done in the US. When you invest in it, you are investing in every business. So, if everyone were to invest in the S&P 500 Index, then the whole market would go up in value. I suppose you could argue that the whole market was in a bubble at that point, but that wouldn't be the fault of the index or the way indexes work, would it?

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

http://www2.standardandpoors.com/servlet/Satellite?pagename=sp/Page/IndicesMethodologyPg&r=1&l=EN&b=4&f=1


*** Exerpt ***
The S&P 500 and S&P's other U.S. indices will move to float adjustment over the next 12 months. Under float adjustment, the share counts used in calculating the indices will reflect only those shares that are available to investors, not all of a company's outstanding shares. Float adjustment excludes shares that are closely held by other publicly traded companies, control groups or government agencies.
With a float-adjusted index, the value of the index reflects the value available in the public markets. Further, reducing the relative investment index investors have in stocks with limited float – stocks that typically are less liquid – should lower the cost of index investing.

The goal is to distinguish strategic shareholders, whose holdings depend on concerns such as maintaining control rather than the economic fortunes of the company, from those holders whose investments depend on the stock's price and their evaluation of the company's future prospects. Shareholders concerned with control of a company include its officers, board members, founders and owners of large blocks of stock. Likewise, holdings of stock in one corporation by another corporation are normally for purposes of control, not investment. While government holdings are unusual in the United States, they are not typically investments made because a stock is expected to appreciate or the government entity is managing its excess funds through equity investments.
Share owners acting as investors will consider changes in the stock's price, earnings or the company's operations as possible reasons to buy or sell the stock. They hold the stock because they expect it to appreciate in value, and believe the stock offers better risk and return opportunities than other investments. Further, a sharp rise or fall in the stock's price could be a reason to adjust their positions. The fact that an investor has held a block of shares for several years is not evidence that the block is being held for control, rather than investment, reasons.
Standard & Poor's defines three groups of shareholders whose holdings are presumed to be for control and are subject to float adjustment. Within each group the holdings are totaled. In cases where holdings in a group exceed 10% of the outstanding shares of a company, the holdings of that group will be excluded from the float-adjusted count of shares to be used in index calculations. Calculation accuracy will depend on the underlying data; however, investable weight factors will be published to the nearest one percent of shares outstanding.
*** end excerpt ***

I personally don't see any problem with indexes. Many other ways of indexing have been tried. The Dow Jones Industrial Index for instance, is price weighted, and represents about 30% of the entire US market cap.

A change of $1.00 of the price of any member of the DJIA produces an equal change to the value of the index. And, lots of people complain about that. They question why a $1.00 change in the price of a 'small' company like GM ($19B market cap) would have the same effect as a 'large' company like XOM ($31B market cap).

Now, the really interesting thing is if you look overlay a graph of the DJIA on top of a graph of the S&P500 Index, they follow each other very closely.

And, if you compare another famous cap-weighted index, the Russell 5000 to both of these, again you will find it remarkably similar.

So, I just don't see any reason to worry about a bubble forming due to any of the market indexes. A bubble could surely form in an index that does not represent the overall market, like REITs, for instance. But that would have nothing to do with the fact that it is cap-weighted.

Russ
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