Indexing Madness or An Indexing Bubble

A must see discussion of today’s index investing distortions   What will turn the tide for active investors. Or read commentary : Q4-2016-Commentary_Final Grant’s Conference Presentation


Q2 2016 Commentary FINAL (See section on ETFs vs. Individual Stocks)

Articles of interest:

11 responses to “Indexing Madness or An Indexing Bubble

  1. Distortions are there for an investor to take advantage of.

  2. Hi John!

    Great Stuff!

    Its interesting to see the risks of ETFs discussion getting traction – Seth Klarman’s Baupost latest letter had a great points as well (Page 14).

  3. An interesting article showing why it’s so hard for active managers to beat the indices:

    The effect Heaton is referring to is the subject of a five-page paper he published in 2015 with colleagues Nicholas Polson and Jan Hendrik Witte; Hendrik Bessembinder of Arizona State University recently expanded their findings. In short: The distribution of returns in the stock market is bizarrely lopsided. Often, equity benchmarks are so reliant on gigantic gains in just a handful of stocks that missing them—as most managers do—consigns the majority to futility. “Your intuition is that you can randomly pick stocks and start at zero,” Heaton says. “But the empirical fact is if you randomly pick, you are starting behind zero.”

    What Heaton and his colleagues didn’t realize when trying to solve the riddle of chronic underperformance is that someone already had done it, for the most part, in a 1998 study, “Why Active Managers Underperform the S&P 500: The Impact of Size and Skewness,” published in the inaugural issue of the Journal of Private Portfolio Management. One of the original authors of the study is Richard Shockley, an associate professor of finance at Indiana University. At the time of publication, Shockley and his colleagues were investigating their observation that the drag from manager fees and the cost of managing a portfolio didn’t explain the degree of consistent underperformance by mutual funds to their benchmarks. The culprit as they saw it: the concept known as positive skew.

    The implication, like it or not, is that a concentration of outsize gains in a minority of index members is tantamount to a death sentence for anyone who gets paid for beating a benchmark. It’s a pattern of returns that virtually ensures everyone outside of an indexer owns mostly deadbeat stocks. “It gets very little attention,” says Rob Arnott, the Research Affiliates co-founder and smart-beta pioneer who’s no stranger to pontificating in the academic realm. “The focus is often on the random walk and the coin toss analogy, and the impact of skewness is overlooked.”

    OK, but an investor who is ABLE to value businesses will be able to find companies mispriced because they have been abandoned for their low liquidity. Opportunity will abound.

  4. Excess breeds opportunity for investors who are insightful, patient and courageous.

    Nick de Peyster

  5. From Greenblatt on ETFs focused on big indexes (especially last paragraph)

    Remember, a market-cap-weighted index ends up having a larger weighting in stocks that increase in value and a smaller weighting in companies whose prices decrease. As Mr. Market gets overly excited about certain companies and overpays, their weighting in a market-cap-weighted index rises. Consequently, an index fund that owns these same stocks ends up being more heavily weighted in these overpriced stocks. If Mr. Market is overly pessimistic about particular companies or industries, the opposite happens. The stock prices of these companies fall below fair value, and the index and the accompanying index fund effectively own less of these bargain-priced stocks.”

    “In fact, the effect of owning too much of the overpriced stocks and too little of the bargain-priced stocks is actually built into the market-cap-weighting system. Again, as stocks move up in price, we own more of them through the index. As stocks move down in price, we own less of them”

    “The more expensive and overpriced they got, the more the index owned. This is the exact opposite of what an investor should want. On the other hand, many companies in traditional industries with solid earnings and good prospects were ignored by the market. Many of these companies were priced well below fair value. Unfortunately, the market-cap-weighted index effectively owned too little of these bargain companies—their low market capitalizations resulted in index weightings that were much too low.”

    “In effect, if emotions really do drive certain stocks to be overpriced and others to be underpriced, a market cap weighting guarantees that we will own an inferior portfolio

  6. Thx for the links. The ramifications of so much money flowing into index ETFs don’t get much treatment in the “popular” press. E.g. Forbes and the Cato Institute recently talked about the pros/cons of the Federal Government “investing” Social Security revenue in the securities market to increase returns [1,2]. But conspicuously missing is any discussion of VALUATION, and what might happen if all those dollars mechanistically chase a small universe of highly-liquid securities. Nope, using a “broad-based index” is seen as a Good Thing because it prevents the government from “picking winners and losers”!

    Returning to an analogy Bregman uses in his talk: if the ETF bubble is like a tsunami wave in the open ocean (unnoticeable, but containing tremendous energy), then central bank money printing is like plate tectonics, the great background force that ultimately gives rise to disasters like tsunamis and earthquakes. If interest rates weren’t being suppressed by concerted central bank action, would we even have this discussion? Would securities of mature consumer “dividend aristocrats” trade at rich valuations implying that the businesses will grow significantly more than GDP?

    This insanity, or predictable failure of central planning, reminds me that value is the ONLY thing that works, even if trends and vagaries point you to different nooks and crannies of the market over the years.


  7. To me it sounds like an excuse for managers when they don’t know where to put their moneys! Come on, there are always pockets in the markets with inefficiencies like spin offs for example. If you know what you are doing you should be able to outperform​ even an bubbled index. If you are Warren Buffett or Seth klarman with billions to manage it might be different / “unfair” to be compared to a bubbled index… But I think for most investors it is just an excuse for below average performance.

  8. John
    you mentioned a good point above :
    “OK, but an investor who is ABLE to value businesses will be able to find companies mispriced because they have been abandoned for their low liquidity. Opportunity will abound.”

    does this mean the able investor can only beat the market consistently if he focuses on out of index and preferably on small or micro cap stocks which present most of the low liquidity on the market?


    • No. But out of index stocks are now MORE LIKELY to be misvalued. Sub $600 million and especially sub $300 million dollar stocks are less likely to be in an index and more likely to be mis-priced–both OVER and UNDER valued.

      An interesting investment is RMT Royce Micro Cap Trust. Stocks there are mostly out of favor and the trust trade at about a 12% discount (the discount has been as wide as 17%).
      Has 300 stocks in the microcap universe. So a double discount. Not a spectacular idea, but you are buying out of favor assets with one of the best managers in the world.

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