[kldaace]

"Yet Mr. Fraser-Jenkins has a point. Index funds don’t set prices; they only accept the prices that active investors have already set. If everyone owned index funds, he says, “no one would be doing” the job of figuring out what securities are worth."

The situation described is clearly not a Nash equilibrium. If you have special, accurate information on the price of a security, then you're going to act on it. Why would no one be doing the work of pricing something if it's profitable? Sounds like actively managed mutual funds are getting antsy because people are starting to realize that they're getting screwed not going with index funds.

[logfromblammo]

If everyone invested exclusively in index funds, and no one works to establish a market price for each individual component, the obvious thing to do would be to adjust indices to manage the portfolio based upon actual dividends.

All companies converge on the same P/E ratio, and the ratio of the index depends on how much investor money is chasing the overall productive activity of every [investable] company in the economy.

It wouldn't be the end of the world, by far.

But it is doubtful this will ever get even close to happening, because some investors will always be gamblers at heart, and if they learn that Coca-Cola is releasing a new beverage flavor, they will use the financial markets to make bets on whether it will be insanely popular or a colossal failure.

[DennisP]

If one company's earnings are growing quickly, and another's is slowly shrinking, and they have the same P/E ratio, I'm likely to skip the index and buy the high-growth company directly.

If a company can reinvest earnings at a high rate of return, it's to the advantage of stockholders if it doesn't pay dividends. How much should the index weight it?

[logfromblammo]

...illustrating why the price system will always be available to value things.

If there is no market trade price for a stock, the only way investors can realize value from owning shares is through dividends. Increasing the value of the company does nothing for the owners individually if shares for a specific company have no individually identifiable price. Everybody is buying and selling through the automated index funds, remember? The only way to get higher capitalization in the opinion of the fund robots is to issue better dividends. There's no one to sell to at a higher price, except the other robots, who all have similar valuation algorithms, and will need to sell the same amount as your fund robot in order to realize any gains.

But that is all absurd and moot, because there will always be a price, as long as two individuals are willing to move differently from the herd. As we are mostly humans in our market, that behavior is practically guaranteed. The outlier who thinks the stock is outperforming the whole market will buy from the outlier who thinks that the stock is underperforming. And their combined beliefs and opinions will create a price for it.

Ergo, index funds are not eating the world.

The fewer people there are that are willing to try to beat the funds or game their algorithms, the easier it will be for any one of them to succeed. So there will always be at least one.

[DennisP]

Which makes me wonder whether there's a strategy that specifically takes advantage of mispricing by overuse of index funds.

First that comes to mind: small caps historically get better returns, and maybe that difference will be amplified by market-cap-weighted funds.

Picking stocks which are growing but not quite big enough to get into larger cap indexes could be another possibility.

[logfromblammo]

An economist and a reporter were walking down the street when a $20 bill blows into their path on the sidewalk. The economist looks at it, smiles knowingly, then steps over it and continues walking. The reporter says, "Why didn't you pick up that $20 bill?" The economist replies, "If it was really a $20 bill, someone would have picked it up already."

By the economist's reasoning, someone already has a strategy to take advantage of index funds. Actually, a lot of someones already have every possible strategy to take advantage of index funds. So none of them really make significant returns, because the dead whale is eaten by a million scuttling isopods, each taking one or two bites before it's all gone. So the real money is in taking advantage of those guys, perhaps with fees or paid reports or little boxes that light up and go "ping".

Of course, just because all the free money is already being picked up, doesn't mean you will never catch a flying $20 bill if you decide to make a grab for it. No market is perfect, and there's always an opportunity to grab some free money somewhere.

[DennisP]

Yep I read Random Walk on Wall Street too, a while back. More recently I read a stack of books on quantitative investing strategies, which referenced a lot of academic work. Turns out quite a few academics don't really believe in the EMH anymore; it's just not holding up to historical evidence. There are all sorts of factors that can make markets less efficient.