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Index Funds are Mediocre

A friend of mine recently told me that she was about to start using a new financial advisor, but she wanted to ask me what I thought of the advisor’s company before she wrote him a check.

The short version is that the advisor was a broker who was trying to sell her a portfolio of super-expensive, actively managed mutual funds. She explained:

“I asked him about index funds, since I know that’s what you and a lot of other people recommend. He said that index funds are mediocre because there’s no chance that they’ll outperform the market.”

The cynic in me couldn’t help but chuckle a bit. “Index funds are mediocre.” It’s a staple soundbite for brokers. Back when I was a broker, I used it all the time.

Hearing that phrase again got me thinking about all the ways that index funds are mediocre. I thought I’d share a few here.

Index Funds are Mediocre

Index funds are mediocre…if mediocrity means being able to obtain extreme diversification with as few as three holdings.

Index funds are mediocre…if mediocrity means being significantly more tax-efficient than almost every actively managed mutual fund on the market.

Index funds are mediocre…if mediocrity means outperforming 60% of U.S. equity funds over the last 5 year period, 60% over the period before that, and 66% over the period before that. (The results are even more impressive for bond funds and international stock funds.)

Index funds are mediocre…if mediocrity means never needing to check your funds to see if any of their managers retired or went to other firms.

Index funds are mediocre…if mediocrity means knowing how your money is invested because your fund company has no reason to keep the fund’s holdings a secret.

Index funds are mediocre…if mediocrity means never having to look at stock charts, watch for earnings reports, or read financial statements.

Index funds are mediocre…if mediocrity means being able to retire with 25% less money (because you’re not spending a quarter of your 4% withdrawal rate just to pay your fund manager).

Index funds are mediocre…if mediocrity means never having to worry that your (seemingly) skilled fund manager will turn out to have just been lucky…and that you won’t find out until his luck runs out.

Index funds are mediocre…if mediocrity means knowing with mathematical certainty that your money will outperform the average actively-managed dollar over every period.

Mediocre sounds pretty good to me.

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Comments

  1. Index funds are mediocre as far as brokerage reps’ payouts are concerned. Lower loads and lower 12b-1 fees mean less sales production credit and less pay in their paychecks when compared to the actively managed strategies they could be selling. Maybe that’s what they mean?

  2. Yes, perhaps that’s what he meant. :)

  3. Niklas Smith says:

    A classic post :)

    And re Dylan’s point, that is probably what the broker meant!

  4. Antonyms of mediocre are superior and extraordinary. I cannot think of one fund class that can make the claim to be superior or extraordinary. Not even hedge funds and private equity funds outperform as a class consistently, certainly not after fees.

  5. Uh, minor complaint here: Is it just me, or how come I can’t seem to locate the date of your postings? For ex, I click though to “as few as three holdings” and it brings me to one of your prior postings … for the life of me I can’t seem to find the publication date to judge how old it is. Then I notice I don’t see ANY dates on ANY of your postings. Why don’t your webpages show something so simple?

  6. DT:

    I used to show the dates on blog posts, as I understand how it can be helpful for readers.

    The problem with showing the date is that it increases bounce rate significantly. That is, many search engine visitors land on the post, see that it’s from 1.5 years ago, and leave immediately. This is especially true for posts covering topics like IRA limits, tax brackets, and so on — which is unfortunate given that these are the very posts I make a point to keep up to date each year.

    So, while I understand that dates can be useful, the honest answer is that, due to what it does to search traffic (and therefore revenue), I’m not going to be re-adding the publication dates on blog posts any time soon.

    (Edited to add: Same thing goes for comments.)

  7. I’m not sure I understand what you mean. I think you mean revenue from this website is an issue if you add publication dates to your postings?

    Really?

    Can’t you solve THAT problem a different way? I mean, if you have posts that are always up to date, then why not change the date to reflect that? Can’t you add a publication date AND and add a “Last updated date” as well? What’s the problem with that?

    I mean, come on, you’ve thrown the baby out with the bath water here.

    It shows a elevated degree of disrespect for the reader to not publish a date with each posting. How can you expect a reader, who may be looking for very current information, to NOT click away from IRA articles published in 2008 when they’re looking for 2010 IRA rules? I don’t understand how you think removing dates is servicing your readers. Seems to me the lack of a publication date might annoy & frustrate a reader, even a loyal reader. Seems to me it only services your website statistics, and thus your ad income.

    Let me ask you this: if you don’t put dates on your postings, how does a reader know that ANY “posts covering topics like IRA limits, tax brackets” is ever up to date? Human nature says someone looking for current information will look HARD for a publication date to verify that what they’re about to read is current. Do you think that the lack of a publication date somehow promotes a particular posting as “current” i the eyes of your reader? You may be fooling search engines, but I don’t think you annoying your readers is worth it.

    Besides, isn’t is possible that a reader might appreciate postings that stay static? For ex: I might like your 2009 IRA postings and other historical touch-points to remain static so that I can reference, say, how the 2010 IRA rules have changed.

    I’m rather disappointed that you think your ad income is an entitlement; and thus you’re making a decision that is truly a disservice to readers because it interferes with your web site search statistics, er, excuse me, your revenue. Frankly, I think this decision is a stupid business decision.

    Reminds me of the RIAA suing their customers in order to keep them.

    Sigh …

  8. Great post, Mike. The idea that index funds are mediocre is such a tired argument. It’s like saying that shooting par on a golf course on every round is mediocre. People conflate the ideas of “earning the market averages” with “earning returns that are average compared with everyone else.”

    I just published a piece about this exact topic, from a Canadian perspective:
    http://www.moneyville.ca/article/890824–why-is-this-new-investment-product-so-hot

  9. Mediocre works for me! Love your blog.

  10. In reply to DT:

    “I think you mean revenue from this website is an issue if you add publication dates to your postings? Really?”

    Correct. I have enough data to say with confidence that revenue declines in a meaningful way when dates are posted.

    “I don’t understand how you think removing dates is servicing your readers.”

    I did not make that claim. I fully agree with you that from a reader’s perspective, dates are a handy thing to have.

    “I’m rather disappointed that you think your ad income is an entitlement.”

    I do not see my income as an “entitlement.” I’m extremely grateful to be able to do work that I enjoy and make a living from it.

    That said, this is what I do for a living, so I don’t apologize for making efforts to maximize the income from my work.

    “Let me ask you this: if you don’t put dates on your postings, how does a reader know that ANY “posts covering topics like IRA limits, tax brackets” is ever up to date?”

    I do my best to include it in the post. For example, “In 2010, the maximum contribution for a Roth IRA is…”

    Then when I update that post for 2011, I update the numbers as well as the dates.

    I fully recognize that this isn’t a perfect solution. But I’m not convinced it’s worse than the alternative, which would be to have wordpress say, “Published on ____” and for me to have a note underneath saying, “Updated on____.”

  11. Dan/Canadian Couch Potato: Great job with that article. Thanks for sharing it. :)

    Petunia: Mediocre works for me too. And, I’m happy to hear you’re enjoying the blog. :)

  12. Hmm.. Why not include the created date and the last updated date??

  13. Investor Junkie: Tried that in 2009. Still results in significantly higher bounce rate.

  14. @Mike: Even at the bottom of the post?

  15. Yep. My hypothesis is that it’s actually a function of Google being able to grab the date (from anywhere on page) and display it in the SERPs.

    In fact, since they display the official “published on” date from WordPress, the bounce rate was actually worse with the dates at the bottom. (Presumably because fewer people bothered to go to the bottom of the page and notice that it had been updated.)

  16. Mike, I like having the dates visible too, but like DT pointed out in his first comment, it’s a minor complaint.

  17. I made the mistake of including dates in my permalinks. Since I’m too lazy to deal with that issue anyway, I don’t think it’s worth removing the dates from posts. That said, I have other sites without dates and Mike is right, it improves bounce rate significantly. Adding a “last updated” line doesn’t seem to improve things.

  18. Hi Kyle.

    Adding the following line to your htaccess file will write 301s for all your permalinks to remove the dates: RewriteRule ^([0-9]{4})/([0-9]{1,2})/([^/]+)/?$ http://www.yourdomain.com/$3/ [R=301,L]

    (I’m guessing you’re already aware of this, since your technical know-how far exceeds my own, but I thought I’d share it just in case.)

  19. I understand what you’re saying, and I do appreciate your efforts with this blog.

    However, I stand by my opinion that it is quite annoying and your decision results in a clear dis-service to your readers.

    Case in point is this exact post: you provide links to your prior posts in this post, which is great. But when I try to find dates to get a feel for “currentness” of these prior writings, that is impossible. And their is no recourse, which makes it even more frustratingly.

    If I’m judging past postings by the date, which can be often in the internet world, esp with fast moving topics like politics and finance, your lack of publication dates make your postings less useful and I’m actually less inclined to read them. (Well, with your blog, I’m fairly up to date. But but when I research topics via google, lack of publication dates on the returned pages can be an important consideration for me.)

    I sure hope you find a way to solve this problem. Even though it is a minor complaint, it is quite maddening and extremely frustrating that something so simple and fundamental as a date is purposefully denied the reader.

    I mean, when someone wants a date of publication, nothing else will do, except for a REAL easy-to-find date of publication. This seems so basic to me, it’s like an inalienable right as a reader! Imagine if newspapers and magazines dropped their dates on all their published material.

    Hmm, maybe on general principle, my complaint is not so minor after all, LOL. I sure hope the vast majority of bloggers do not follow your lead.

    Please keep this issue on your radar and return all publication dates to your postings as soon as possible.

  20. Beg pardon, but what exactly is a “bounce rate” anyways?

    And why is it important?

  21. “Your lack of publication dates make your postings less useful and I’m actually less inclined to read them. “

    I understand that. All I can tell you is that I know with a high degree of certainty that you’re in the minority. The data provided by my analytics software makes it very clear that a page is more likely to be read without the date on it.

    I get that you’re frustrated. And I’m sorry. But it would be dishonest of me to indicate that I’m seriously considering re-adding the dates.

    Yes, it’s a selfish decision, but I can’t justify the decline in revenue that results from including published-on dates. (Historically it’s been ~15% of revenue. So when considered as a percent of monthly profit–i.e., my personal monthly income–it’s higher.)

  22. A “bounce” is a visit in which the visitor lands on the page, then leaves before clicking on anything (such as another article or an ad). “Bounce rate” is the percentage of overall total visitors who do that.

    It’s often used as a measure of visitor engagement. That is, the higher the bounce rate, the less engaging visitors seem to find your site.

    Or it can be used as a stand-in for a host of other revenue-related metrics (in that higher bounce rate generally means lower rate of ad clicks, lower rate of people who subscribe to the blog, and just generally lower rates of people doing the things you hope they do when they visit your website).

  23. Thanks for the explanations. I’m amazed that lack of publication dates has a material impact on bounce rates, er, I mean, revenue.

    Part of it makes sense though, right? Someone is looking for timely information, finds a publication date beyond his desired range, and clicks away to continue his search.

    Reading between the lines is that: you found that by removing the dates, you’ve prevented casual clickers from making that split second decision to click-away based upon publication date. No dates mean they stay longer. I mean, no date may mean that a casual reader stays on your website longer because they can’t find the instant reason to click-away so quickly, so they read a bit more, all the while perhaps looking for a date, but nevertheless engaging with your blog, and possibly the ads, as well.

    I still think that that is a bit sneaky and disingenuous thing for a blogger to do, to remove the dates. But you’ve made a clever observation, nonetheless.

    Here’s hoping that decision bites you in the ass, or at least nibbles at you a bit. I think this would be a poor trend would other bloggers adopt your policies; it would make the web an overall less useful place.

    I think this is what I don’t understand: What is the relationship bounce rate and revenue?

    Btw, while we wait for your ass to be nibbled, please continue with your observations on your blog. I’m a loyal reader, and I’m not going anywhere.

    -End of Rant-

  24. “By removing the dates, you’ve prevented casual clickers from making that split second decision to click-away based upon publication date. …A casual reader stays on your website longer because they can’t find the instant reason to click-away so quickly, so they read a bit more, all the while perhaps looking for a date, but nevertheless engaging with your blog, and possibly the ads, as well.”

    Bingo.

    “I still think that that is a bit sneaky.”

    Frankly, I’d agree with that assessment. (Though I don’t think I’d call it disingenuous.)

    “What is the relationship bounce rate and revenue?”

    You nailed it in the bit I quoted above. The longer a person stays on the site, the more likely they are to click an ad, click to Amazon for more info about one of my books, or subscribe to the blog (and click an ad or buy a book later).

  25. I re-read your reply about how bounce rate is a “stand-in” for other metrics. My question “What is the relationship [between] bounce rate and revenue?” is no longer necessary. I think I get the general picture.

    Gosh, but I do wish your observations were incorrect.

    I still find myself wanting a publication date … somewhere.

    What about an index page with the dates and links to your posts?

  26. You realize you can have the date as an image or obscure the date via javascript (though Google can and does read some javascript).

  27. Yep. Already bought two of your books.

  28. This page has posts sorted by month: http://www.obliviousinvestor.com/archives/

    I’m trying to think of a way to use Google to see when a page was first indexed. So far no luck, but I imagine that it’s doable…

    Also, thank you for buying two books. I quite appreciate that. :)

  29. Investor Junkie: That’s an interesting thought–date as an image, that is. Intentionally using JS to obscure things from Google scares me. :)

  30. The monthly archives are not useful when trying to answer the question “What date ‘D’ did Mike post article ‘X’”?

    Given that I might find article X first, your blog lacks a feature to quickly discover date D. The archives help when going fom D->X but not with going from X->D.

    Knowing date D is still a useful thing to know sometimes.

  31. Update: A query of this nature in Google would determine the date of an article. Though admittedly, that’s still a pain in the butt.

  32. I’ve been too lazy to look at index funds, but I will be moving my Simple company plan soon so will be taking a gander. Do you know if Charles Schwab offers index funds?

    Also, btw, being an internet marketer as well I can appreciate wanting to do everything you can to reduce bounce rate and increase revenue. People who are readers and commenters don’t generally make the best ad clickers.

    But, since you also offer books, they may be more likely to purchase a book which I’m guessing has a higher profit margin than an ad click. So a fine line to walk.

    Sounds like you know your data, though. Buyers and clickers pay the bills. Readers looking for a date, may not. (Except for DT :O) )

  33. Hi Chris. Yep, Schwab offers very cheap index funds. They also have commission-free trades on super-low-cost ETFs. (Though I don’t know whether or not those would be available via a SIMPLE.)

    You’re right about books having a higher profit margin than an ad click. But, the same exact thing applies. No “published on” dates leads to higher CTR to Amazon, not just Adsense.

  34. Two things:
    First this comment: “Index funds are mediocre…if mediocrity means never having to look at stock charts, watch for earnings reports, or read financial statements.” Buying a mutual fund in the first place, active or indexed frees you from those chores but adds several others to the list of equal, if not vital importance.

    If I was to have a problem with index investing, it is this mindset. Yes, index funds are easy (much preferred over mediocre) and while they do add to diversity, they also suggest that investing with these funds is a set-it-and-forget sort of investment technique. Just because they are index funds, and the vast majority of them are owned inside a self-directed plan like a 401(k), doesn’t make them the best overall option.

    This presents a couple of additional problems: not all index funds cost the same (inside a 401(k)) and the tax efficiency of these funds defeats the real reason you are using a tax-deferred plan – to defer taxes.

    Index funds do invest across a broad range of stocks or bonds but they still need to be monitored, checked and reviewed. Simply channeling money in and never considering that perhaps there might be something better suited doesn’t teach investing; it fosters hope.

    I have never been a huge fan of the comparisons of index funds vs. actively managed funds. Ask an index fund investor how many companies are owned in the Wilshire 5000 and I’d be willing to bet they’d say 5000 companies. (No they don’t.) Take it one step further, ask them if the fund invests equally among all of the companies in an S&P500 and they’d probably think this was so (the top ten companies make up the top 10% with the remaining 490 getting successively less investment dollars). Ask them a trick question: is buying low and selling high good investment technique or is selling low and buying high better? (The later is what index funds do when they rebalance each year, kicking losers out – based on opinion – and buying this year’s winners.)

    I’m not knocking them – I own them as well – just on the outside of my 401(k) where they do best. The ability to get actively managed funds inside a 401(k) provides some risk, often a more narrow focus on a specific part of the marketplace, and it forces you to learn about your money, your investments and how to plan for your future.

    Consider this method to snag the tax advantage: 10% to your 401(k), then 5% to your index fund, then back to your 401(k) when you can afford to do so.

    The second thing: dates do matter but content is what drives revenue. I still marvel at advertisers who contact me for a text link on article written five or six years ago. Granted, I’ll update the page in the process. Yet search engines love legacy the way readers love good content.

  35. I understand that in the readers-vs-revenue war, revenue wins. It still seems antithetical that revenue wins at the expense of readers, when readers is the whole point of why you produce content. (Don’t say that casual clickers are more important than readers; that just seems so galling as to be backwards; even if it is true.)

    Disingenuous still seems appropriate to me. Maybe as an individual hard-working author, you don’t see it. But as a content producing blogger, yes, I think the term applies in a broad general sense to what is going on.

    I’ve always envisioned a “contract” between blogger and reader, similar to other content producers (like newspapers and magazines), whereby (among other things) the consumer of the content knows the publication date of what he is reading.

    If you added a disclaimer #3 to the bottom of the page, with a brief and frank explanation of why you don’t show dates of publications (that by displaying dates, your blog produces less revenue), then I think the disingenuous label could lifted.

    Ok, enough said. Thanks for all your hard work, Mike.

    Btw, loved “Taxes Made Simple” and “Accounting Made Simple”.

  36. Nice! Great way to present the case for index funds. I am a huge fan myself.

  37. To me, the question of publication dates just falls in the broader category of optimizing for reader experience as opposed to optimizing for revenue. It’s a spectrum, with many decisions to be made.

    For example, I can opt to show no ads, a few ads, or a ton of ads. From the readers’ perspective, it’s clearly preferable to have no ads. But, from my perspective, that’s just not an option.

    At the same time, I try not to go completely overboard. I keep it to two ad units and a blurb promoting my books. (And the biggest/most intrusive ad unit only shows on posts more than 2 weeks old in an explicit attempt not to annoy frequent visitors.)

    Similarly, the topics that I do or don’t write about plays a role in how much income the blog produces. (For example, I could write a lot more “Lending Club Review” and “____ Bank Review” articles than I do, which would generate affiliate revenue.)

    To me, “published-on” dates are just another question in that whole range. (One in which I’ve admittedly opted for the “make more money” path.)

    In other words, I don’t see this decision as any different from my decisions of how many ad units to include, where to place them, what color to make them, and so on (which is why I feel no special need to explain it–though when asked, I’m happy to do so).

    “Don’t say that casual clickers are more important than readers; that just seems so galling as to be backwards; even if it is true.”

    I won’t say that. Because it’s not true. :)

    From a perspective of enjoying my work, having regular readers makes it a heck of a lot more fun. And from a purely business perspective, regular readers are the ones most likely to buy books, tell other people about the blog, etc.

    I will point out, however, that in a given day, ~4,000 people show up at the blog, and 90% of them are first-time visitors.

    So on a one-to-one basis, yes, regular readers are far more important. That said, there are 9-times as many first-time visitors everyday, so it’s important to weigh that in the decision-making process as well.

  38. Ever wonder why the 90% of first-time visitors don’t become regular readers?

    I certainly don’t have an answer, but IMHO the lack of publication dates certainly do not encourage the average new visitor to become a regular reader.

    You admit you are taking the bottom-line bean-counting corporate management point of view. I understand that. But that view does not always benefit the readers of this blog, and, in fact, can be counter productive to acquiring and keeping them, especially the new ones.

  39. “Ever wonder why the 90% of first-time visitors don’t become regular readers?”

    Yes, I spend a lot of time thinking about it.

    I understand and accept that some people will choose not to stick around as a result of no dates being shown. But the data makes it clear that for every person who leaves because of no dates, more than one additional person sticks around. That’s exactly what the bounce rate metric shows.

  40. Can you point to any data about the cumulative impact of lower fees in index funds vs. higher fees in active funds? That seems to me it could be the clincher in favor of index funds, yet I can’t point to any hard evidence.

    I don’t care about the “dates” thing; for me using the Archives page is good enough.

  41. Hi Larry.

    What data, specifically, are you looking for when you say “cumulative impact”?

  42. What I’m getting that is something like this: I have friends who loftily dismiss the idea of index fund investing by saying that their managed fund expenses are “only” 1 or 2% of the fund’s value. I tend to think that over time, that 1 or 2% will compound so that it eats into a gradually larger percentage of the investor’s returns. Am I right about this?

    Unrelated question: Have you reviewed Jonathan Pond’s book on retirement planning?

  43. Yep! That 1-2% sure does eat into returns. (And it’s not surprising given that long-term after-inflation returns on a mixed stock/bond portfolio are what? 4-6%?)

    Anyway, either of the two following studies might be of use, though there are many.
    How Expense Ratios Predict Success (This one now requires a (free) morningstar account to view the article.)

    S&P’s “SPIVA Scorecard” (They put out these figures every year showing what percentage of funds outperformed their respective indexes over the prior five years. And every year, it’s bad news for actively managed funds.)

    And no, I have not read Jonathan Pond’s book. (In fact, I hadn’t heard of it until now.) Have you heard good things?

  44. I think a side-by-side comparison of two portfolios growing the same percentage over (say) 20 years, but with one having fees of 1% and another fees of .1%, could illustrate the point.

    I’m reading Pond now and he seems pretty sensible, but he’s not a die-hard indexing fan and recommends a blend of index and solidly managed funds, possibly with some individual stocks paying high dividends.

  45. I added a new tab to my “historical returns” spreadsheet that should be approximately what you’re looking for. (It shows how $100,000 invested in a 50/50 portfolio with 0.1% costs would compare to the same thing with 1% costs over historical 20-year periods.)

    (Important note: By “stocks” I mean S&P 500, and prior to its existence, the S&P 90. And by “bonds” I mean total return on a 10-year Treasury bond. Admittedly, that’s not how I’d actually construct a 50/50 portfolio if I were to do it myself, but it’s the only data I have that goes back very far.)

  46. Thanks. Put simply, you seem to be saying that the lower-cost portfolio will outdo the higher-cost one by about 15% over those 20 years – am I correct?

  47. Well, that appears to be the case with this particular set of data. I can’t say for sure that that would be the case with a different allocation or over periods with different returns.

    That said, it makes sense.
    1 x 0.999 ^ 20 = 0.98
    1 x 0.99 ^ 20 = 0.82
    …a difference pretty close to 15%.

  48. @DT – the problem with blogs is that nobody will pay to read them. Therefore bloggers have to earn money other ways (ie third party advertising/products etc). This unfortunately means that the readers are not always the primary concern.

    The reality is that writing free content for the regular readers gets old after a while and making some money is a great incentive to continue.

    If bloggers can’t make money, then most of us would probably blog a lot less than we do.

    Think of it this way – what scenario would you rather have?

    1) The existing one where content is free, but bloggers do things to make more money which are not always in the best interests of the regular readers.

    2) Pay-to-read. Regular readers would have to pay to access blog content. The upside would be that the readers interests would take priority over advertisers and search engine visitors since they are paying the bills.

    Don’t say that casual clickers are more important than readers;

    Most regular readers don’t click ads, some search engine visitors (aka casual clickers) do. The clicks/purchases pay the bills.

    If you ran a book store and had a group of “regulars” who spend a lot of time in the shop reading your books and rarely buy anything, would those people be more important than the casual passerby who walks in and actually buys some books?

    Mike

  49. Larry

    >I think a side-by-side comparison of two portfolios growing the same >percentage over (say) 20 years, but with one having fees of 1% and another >fees of .1%, could illustrate the point.

    Here is an example I wrote up for my blog, and since I have the post dates it’s clear I’ve been pretty inactive for a while :-)

    “Would you be willing to examine your mutual fund fees for a quarter of a million dollars? Could it make that big a difference? Say you invest $5000 per year in a mutual fund that returns 8% over 40 years with a 1% fee, how much would you have? Over a million dollars ($1,093,898)- compound interest is a wonderful thing! However, if you could invest in a different mutual fund that returns 8% over 40 years but has a 0.25% fee then your total grows by 23% to $1,351,458.93. That’s a $257,560 increase for a 0.75% lower fee! Every penny paid in fees or transaction costs is money that isn’t going to grow for you. In many area of life you get what you pay for, but in investing you get what you don’t pay for!”

    I also have a graph that shows returns for different %es:

    http://ponderingmoney.com/2009/10/12/you-need-to-understand-compound-interest/

    -Rick

  50. Can you explain how an index fund is priced? Is it dependent on the value of the index being tracked (primary value) or is it dependent on the amount of money that investors are prepared to pay for the index fund (secondary value)? Or both? In other words, if a huge amount of money streams into an index fund, how will it affect the price of the index fund shares?

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