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Author: Viznut Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75383  
Subject: Percentage of Market in Index Funds Date: 8/13/2005 8:19 PM
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Does anyone know where to look to find out what percentage of US/int'l stocks and bonds are held by index funds?

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.).

If so, then it intuitively seems to me that this is a problem with indexing. Thoughts?
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Author: DeltaOne81 Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 47218 of 75383
Subject: Re: Percentage of Market in Index Funds Date: 8/14/2005 10:50 AM
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There could be an indexing bubble as you seem to be getting at, especially for the big indexes like S&P500 or the DJIA. It might be a wise idea to keep your eyes on that situation.

The good news is that, for real long term investors, so long as the value of the companies keep climbing as they always have, on the long term, the market prices will follow that. There could be a bubble and a pop in the middle, but in the long term, you'll still make money at around the long term rate.

I believe the indexing rates are most based on number of outstanding shares, although you could say that's affected by investor sentiment in some ways.

But I think this brings up a good point that even index investing, especially in tax-free accounts, isn't "set it and forget it" (Ron Popeil style). If you think an index is way overvalued, like the Nifty 50 in the 70s, then you should probably take note of that and consider moving at least some elsewhere.

This is also a good reason to not be just in one index, but to have a good portion of your assets in less popular places like the Wilshire 5000, Russel 2000 Small Cap, MSCI AEFE (foreign), and a perhaps a number of others. There are even 'value' indexes. I don't know how they're defined exactly, and you should certainly look into that, but you can pretty much guarantee yourself that you won't be holding very high P/E stocks in those - even bond indexes, REIT indexes.

Even indexes, diversification is important as is keeping an eye on things.

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Author: ziggy29 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 47219 of 75383
Subject: Re: Percentage of Market in Index Funds Date: 8/14/2005 10:58 AM
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>> There could be an indexing bubble as you seem to be getting at, especially for the big indexes like S&P500 or the DJIA. It might be a wise idea to keep your eyes on that situation. <<

The S&P 500 has been one of the worst-performing indexes of the last five years. So if it's overvalued, there's really not much of a place for an indexer to go. Still, that's why rebalancing periodically is such a good idea. It forces a discipline of selling some of the high-fliers to buy some of the laggards on a regular basis.

#29

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Author: cliff666 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 47223 of 75383
Subject: Re: Percentage of Market in Index Funds Date: 8/14/2005 12:43 PM
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The S&P 500 has been one of the worst-performing indexes of the last five years. So if it's overvalued, there's really not much of a place for an indexer to go.

True, the S&P has been in a correction mode for years. But my Vanguard Extended Market Index Fund (VEXMX) has done just fine. There are more indexes than just the S&P 500.

cliff

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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: 47225 of 75383
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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Author: Viznut Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 47243 of 75383
Subject: Re: Percentage of Market in Index Funds Date: 8/15/2005 10:58 PM
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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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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: 47256 of 75383
Subject: Re: Percentage of Market in Index Funds Date: 8/16/2005 7:04 PM
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Author: Viznut | Date: 8/15/05 10:58 PM | Number: 47243
>>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.


The effect that you are pointing out might be present, but with hundreds of stocks in any given index, and no single holding being more than a small percentage the total outstanding shares, the effect on the overall index would be minor.

Also, the weighting of the index itself is recalculated by computer, nearly instantaneously, all during the day. You can check to see how any index fund is performing against its index by looking at its tracking error (computed after the close each day). You will find that all of the major funds (SPY, VFINX, etc), have extremely small tracking errors, meaning that any effect like the one you are pointing out has been historically insignificant.

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.

Lots of things soften the effect of other changes. I believe that the effect you have highlighted is just one contributor of many to the imperfect efficiency of the markets. There are many time related effects that tend to make market reaction to various events delayed from the event. This is what allows some traders to be able to beat the market. However, with modern computerized trading, efficiencies are only getting better and better.

I just don't see any worry whatsoever of a bubble being caused by large index funds.

Russ

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Author: Viznut Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 47259 of 75383
Subject: Re: Percentage of Market in Index Funds Date: 8/16/2005 8:24 PM
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rkmacdonald:
Also, the weighting of the index itself is recalculated by computer, nearly instantaneously, all during the day. You can check to see how any index fund is performing against its index by looking at its tracking error (computed after the close each day). You will find that all of the major funds (SPY, VFINX, etc), have extremely small tracking errors, meaning that any effect like the one you are pointing out has been historically insignificant.


I didn't know that. Thanks for the information, Russ.



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