In an index the goal is to buy everything of a kind: all of the stocks in the S&P500 or all of the stocks listed on the NASDAQ. A handful of people aren't arbitrarily deciding which of the 500 biggest companies are.
The goal of the index investor is to get average performance - active traders can worry about the microeconomics. If too many people index invest then there will be huge market inefficiencies for active traders to make money on, which will attract more traders to the market, which will make the market more efficient.
Right...
https://www.cnbc.com/amp/2017/08/01/sp-500-to-exclude-snap-a...
Edit: note that Fortune 500 and the S&P 500 are not the same list.
There is only individual intelligence, which can act with other individuals. That is, there are only individual investors - actors - whether we're talking about retail or hedge funds or even AI bots. There's no seven million headed investor automagically sharing a brain and its accumulated wisdom. The point being, each investor that is acting on the market, is acting from different conclusions (even off of exactly the same data), with different intent, and with different capability of deduction and discipline and implementation and so on.
Most of the professional investors that manage money for others are not very good at generating returns. They tend to be horrible at taking advantage of the vast market inefficiencies that made Warren Buffett and dozens of other famous examples possible. To make matters much worse, said mediocre professional investors then make their money by skimming off the capital they manage. When that's your scenario, index investing will always make sense. The only time it doesn't, is if you possess numerous rare attributes that make it possible to take advantage of the inefficient market, or if you can find a rare someone to trust your money to that can do so.
How does one find market inefficiencies? Elon Musk's First Principles analysis is one thing that comes to mind.
[1] http://www.marketwatch.com/story/john-bogle-has-a-warning-fo...
Also of note index funds do have feedback loops as they try to retain a balanced portfolio. If company A is worth 1 billion and company B is worth 2 billion yet they have equal dollar investments in both, then they sell some of A to buy some of B. This greatly magnifies the impact of active traders in a 99% ownership situation.
> If company A is worth 1 billion and company B is worth 2 billion yet they have equal investments in both, then they sell some of A to buy some of B.
This is a paradox -- both of these are examples of market movements which require the percentage of stocks held outside of index funds be equal to or greater than the volume required for the price movement. The critical point is much lower, and as more people buy into index funds, the active traders make more money rebalancing and therefore are able to increase their own positions, providing negative feedback and preventing the index fund ownership from rising more. I don't know what the asymptote is, but I suspect it's closer to or equal to 50%.
Another way to think of it is that markets would be incredibly illiquid with 99% index fund ownership -- that's not much ownership for market makers, but their profits would be tremendous due to the thin order books, driving in more market makers and thereby increasing their market share until it's no longer easy money.
My point about ownership percentage was simply that passive traders and active traders only interact when the total amount of stock changes. But, passive traders are simply speeking a fixed ownership percentage which means they don't change the final price only the active traders who must end up with that same 1% based on price movements.
If they own 1M$ of A and 1M$ of B, but B is worth more than A then they sell some of A to buy some of B.
Keep in mind that this doesn't (at least not naïvely) happen when one of the two increases or decreases in value relative to the other.
For me, the most interesting observation in the article is that poor active returns are a sign of market efficiency.
As in: you select the stocks and their proportion and supply the money/demand money out, and stocks are then bought/sold automatically?
Say I want to follow index X, but I don't want stocks in oil or coal companies because I believe they're going to die before I need the money out. There doesn't seem to me to be an easy way to build that customized index.
I guess you need a low-fee stock broker and an algorithm that's aware of the fees for this to not end up drowning in fees.
When you buy and sell shares in the "real" market, you do so in whole numbers. If you're going to construct an index fund just for you, the smallest amount of any stock you can buy is 1, so you'd need an enormous capital investment: if you want e.g. 1% of your fund to be Google (currently trading at $934), and assuming all the share prices work out just right -- in practice, they won't -- your smallest unit of investment would be $93,400.
In practice, the closest approximation of what you describe is just having a passive portfolio: pick a bunch of stocks, buy them, and then don't look at them again.
Basically, you determine the dollar amount you want to spend on each stock, and the plan purchases that amount, including fractional shares.
I don't think they do the same for selling.
http://www.sectorspdr.com/sectorspdr/
So, you can either:
1) Buy all the sector ETFs (XLY, XLP, XLF, XLV, XLI, XLB, XLRE, XLK, XLU) except for the energy sector (XLE)
2) Buy the SPY, short sell XLE.
Different tickers apply for iShares, or other indicies / sectors, but you get the idea - it's easy enough to focus on specific sectors using a mixture of ETFs.
Have fun,
Edit: I see a $110M Series C in April '17 reported for Robinhood.
Not great for research, but functional to buy/sell.
The business actually has little need to get involved at all in its stock market listing if it is just getting on with its business.
It's only when you start using shares as currency to buy other things (whether manpower or other companies) that secondary listings and the ability to swap them into cash starts to matter.
There's a fairly reasonably argument that a stock market in its modern construction is actually more of a hindrance to genuine equity investment and it shouldn't exist. Then those investing in equity have to look at the ability of the company to generate an income rather than sell itself to the greater fool.
Post-IPO, companies can also raise additional capital by issuing more shares (either to the public or by e.g. issuing RSUs to employees). Only in those cases is the stock price relevant. Otherwise, the market can be mispricing a stock without any bearing on the functioning of the company.
It wouldn't, because there isn't anything else they can do with the capital other than sit on it in a bank and get no return.
The myth that the stock market is relevant is put about by people who work in stock markets. Much like share buy-backs are the same as dividend payments. Exactly how giving the company's money to people who want to stop investing in the company is the same as giving it to those that do is a triumph of using dodgy maths and statistics to fool people.
I just don't follow the reasoning that stock price enables resource allocation.
Companies can issue bonds if they want to raise large amounts of capital. Those are traded on a different market and are fundamentally different than stocks. They are debt instruments, not ownership.
There will be an inflection point where stocks in indexes are so overvalued that enough active investors (and passive defectors) cause a rebalancing. If they're overvalued enough, and enough of the general market participates in them, index funds could easily crash.
Apps like Robinhood are making active investing much more feasible for your average Main Street person. I certainly am not counting on the continued blind investment in index funds.
This presumes that the only reason stocks are in the index is because of index investors, which is not the case.
I think a way to look at it is what earnings multiples companies trade at signals to companies how much money they can raise in an IPO or follow on equity issues.
For example, if Boeing is trading at 5X EBITDA then it signals to other aerospace and defense companies that they can expect to raise capital at a similar multiple.
It's indirect, but it still provides a service: creating a predictable, liquid securities market which firms can use to raise capital.
People invest in an IPO in the first place because of the promise of liquidity down the line.
If investors were told that they couldn't freely buy or sell shares after the first time it is sold, the IPO is going to do far worse.
The ability to trade the stock around directly helps the company by making the IPO more successful.
That's not even considering that the company could issue secondary offerings.
They didn't anticipate _your individual_ actions, but it's highly likely that the persons that bought into Facebook's IPO did expect that they would be able to sell the stock to _someone_ at a later date.
So, yes, people anticipated your actions now (if you look at _your_ actions as the general actions of the crowd, instead of your individual actions)
By buying Facebook stock now, you're fulfilling that expectation of earlier investors, which motivated them to provide Facebook's initial funds.
Liquidity along with higher prices along with improved business metrics, which provide perception and confidence to the market to promote higher prices, are used by the business to obtain cheaper financing and the employees of the business to also obtain access to credit based on their holdings of the stock.
These are colloquially called resources to businesses.