[Arn_Thor]

> 7. Index fund managers are not incentivized to exclude a SpaceX from their indexes. (?)

Correction: index funds don't have a choice. They must follow the index, and so must buy the stock.

side effect: they'll have to sell other stocks, pushing their prices and weighting in market cap weighted indexes down.

> Passive investors are unable to rapidly respond to these types of changes because liquidating portfolios will incur capital gains taxes. (?)

For some active investors, yes. For passive investors (say you through your employer's pension fund), the tax isn't the problem. It's that the market has such a short time to adjust the price of these companies before indexes are forced to include them--and so might buy them at wildly inflated prices. Then, not too long after, the early investors can sell at still-high prices as soon as their lockup periods end. It's a massive transfer of wealth from pension funds and index investors to the early investors in those companies.

[bluGill]

> Correction: index funds don't have a choice. They must follow the index, and so must buy the stock.

Maybe, most indexes do not have to follow the index. they just need to match the returns. An index fund manager has choice of what stocks to buy. However an index fund doesn't have enough managers to make many choices and so they normally buy just what is in the index. However all index fund managers know they are large enough that if they change their holdings "instantly" when the index it self changes the market will collapse and so the fund will under perform. Thus index fund managers are always trying to figure out what the index will do so they can start buying/selling stocks in smaller amounts before the change happens.

How each fund handles this is up to the managers. (and "total market" funds have less ability and need to do this)

[gitfan86]

The whole point of index funds is that you don't have to pay management fees to managers. It's very expensive to hire a team of people to analyze the entire stock market in detail and chose the best 500 companies, and historically people who did that on average didn't beat the S&P500.

Just look up the performance of Mutual Funds vs S&P500.

[bluGill]

That is the point, and index funds pay many less managers. However they all have a few managers to handle the various paperwork needed and those managers do make some decisions. They have much less influence vs a traditional funds, but it is slightly above zero.

[daveshistory]

I think the point is that they don't have the influence to intentionally deviate from the index because they think they know better. If your mandate is to be passive, then you need an index to follow. If you are that sure the S&P 500 index is wrong for some reason, or whatever other index you follow, then you need to invent a new index. Then, you can follow the new index.

[bluGill]

At least my index funds do that. They don't get to constantly trade like non-index funds do, and they typically stick with the index, but every index fund I own has a line about "we select stocks that we think will match the index", which is different from buying the stocks from the index.

Again, the vast majority of the time they are matching the index stocks. However they have the right.

[daveshistory]

I guess that's true but put yourself in the position of a major fund manager. Would you rather explain "We lost 3% this year because of a dumb IPO because we track an index that includes dumb IPOs," or would you rather say, "We lost 3% this year because I decided, as a passive fund manager, that the index was wrong and I knew better"?

Your career would be over.

Or at least, you would have to transition over to an active fund!

[kmbfjr]

And their tax efficiency over mutual funds when outside tax advantaged accounts.

[Arn_Thor]

The problem is, if you deviate too far from the index, your head is on the chopping block. There is no incentive to outperform the index, and every incentive to not meaningfully underperform it. Anyone bought into an index fund expects exact index performance (whether or not the prospectus technically allows for deviation).

So any manager who values his pay check will say "the index may go up, may go down. The investor's paper wealth may increase or decrease. That's not my problem! And in a market like this, I risk underperforming if I don't own this asset. So of course I'm going to buy it!"

[kybernetikos]

> Maybe, most indexes do not have to follow the index. they just need to match the returns.

This is a great technical point, and in a scenario where a constituent has a lot of obvious correlations it might be relevant, but when you've got something that is effectively a meme stock with erratic leadership and a huge range in possible outcomes from bankrupt to most valuable company ever in the universe [claude tells me I should say 'idiosyncratic returns' instead of this rant], I don't see how you promise to match the performance of an index where it's a significant component except by buying it.

[nradov]

They'll buy it, but they'll build a position gradually over months to approximately match the index. It won't be huge block buys on the IPO day.

[convolvatron]

but any upside to second guessing the index gets allocated to the management, right? just like any downside, so its kind of immaterial for the end users, they're effectively bought into to SpaceX anyways

[bluGill]

They are judged by how close to the index their returns are. If there a significant deviation either way they are judged harshly. Each fund is different, but they typical thing they will do is buy a competitor of some company in the index once in a while.

Typically managers pay is such that they don't get awards for guessing correctly, so they won't get any upside from a correct second guess, and they will see downsides from incorrect guesses.

Also unlike traditional funds, there are not enough managers to follow every company, so they can't pick stocks that will win just because they don't have enough to time research the stock. When they pick a stock they are just looking at the high level will this company perform like the other peers in the industry long term.

[jayd16]

So are they incentivized to allow an obvious grift and let the index have middling returns so they can skim the difference?

[bigfishrunning]

But surely the managers of those pension funds can see this happening, and will not likely take on the risk of shares that are that young, no? The index funds hands are tied, i agree, but passive retirement funds are largely managed by people who are motivated for them to succeed. If this were not the case, then pension funds could have been looted long ago...

[daveshistory]

Pension funds that are actively tweaking the mix of stocks they hold likely might decide to play it safe.

On the other hand, do you want to be the one who says, "As a rule we follow the index, but this time we decided to break our own rule, and as a result we lost X% of returns"?

Better wrong with everybody else than wrong on my own.

[dragonwriter]

The reason pension funds include index funds in their mix of investments is because those funds have two features that are exactly what pension funds are aiming for: (1) broad diversification, and (2) conservative inclusion rules that avoid undue exposure to highly volatile firms.

Changing one of those features undermines the reasons for including the index. Doing it specifically for the purpose of including a firm where large pension funds have also been extraordinarily critical of the governance structure as a particular source of risk [0] even moreso.

[0] https://www.reuters.com/legal/government/new-york-california...

[daveshistory]

I was looking at it from a more institutionalized perspective I guess. At least in my field, I know how this works because I see it play out. People are conservative and sometimes would rather be wrong with the herd as long as it means they're not risking being wrong on their own.

Having said that I guess you have a valid point. Once major institutional investors decide an index has basically gone corrupted, then they won't actually buy the index fund anymore. They will just buy all the stocks in the index, and underweight the parts they think are tainted. That's what I would do, anyways.

[conartist6]

Mmmm legalized theft: the new Tech Industry!

[SilasX]

>Correction: index funds don't have a choice. They must follow the index, and so must buy the stock.

Right, if they've advertised as an S&P 500 index fund, they have to robotically follow the S&P 500, stupid inclusions and all. Changing that strategy would require ... a lengthy process involving input from shareholders.

However, someone can still start e.g. a "classic S&P 500" fund that follows the old rules for inclusion, and I suspect we'll see that in response to these recent decision.

[nradov]

It's not the advertising that matters, it's the prospectus. Read the prospectus for any index fund and you'll find that out gives the fund managers a lot of leeway.

[SilasX]

Sure, I was simplifying a bit with the technicals. But you're sure their leeway is enough that they can say "nah, we don't like what the index is doing now, we'll do our own deviations from it?" That seems implausible but I don't know enough about mutual fund/ETF regulations to say for sure.

[nradov]

Yes, I'm sure. You can just read the prospectus itself. Here's one of the biggest ones.

https://investor.vanguard.com/investment-products/mutual-fun...

[SilasX]

I'm aware I can read the prospectus. And, to the extent that I found the relevant portion of the prospectus (that you could have done yourself and posted) here's what I see:

>The Fund employs an indexing investment approach designed to track the performance of the S&P 500 Index (the “Target Index”), a widely recognized benchmark of U.S. stock market performance that is dominated by the stocks of large U.S. companies. Under normal circumstances, the Fund invests at least 80% of its net assets, plus the amount of any borrowings for investment purposes, in the stocks that make up the Target Index. The Fund attempts to replicate the Target Index by investing all, or substantially all, of its assets in the stocks that make up the Target Index, holding each stock in approximately the same proportion as its weighting in the Target Index.

That doesn't sound like a lot of leeway to arbitrarily ignore major new additions that make up a few percent of the index. They'd have to say "no, we're not holding each stock anymore".

It would be more informative to see SEC or court rulings on a mutual fund that tried something like this.

Or, we could just go the way HN normally works, and settle it by who can write the most confidently.

[Arn_Thor]

I'd be in line to buy today!

[supertroop]

I’m an index investor. I still need to sell to see the gains. So that’s a tax penalty. What am I missing?

[nradov]

A large fraction of index funds are held in tax advantaged retirement accounts such as Roth 401(k).