In reply to my post at MoneyNing last week, one commenter (a writer for FiLife) replied that:
“Index funds NEED actively managed funds or stockpickers in the market. The market moves when people have opinions on individual stocks, sectors and ideas.”
Am I missing something? As far as I can tell, this statement represents a flawed understanding of the nature of the stock market.
Sure, over the short-term, market returns are the result of changes in demand. But over the long run, market results have more to do with corporate earnings than they do with fluctuations in the demand for stocks.
Example: $100 invested in the market in 1928 would have been worth $112,990 by the end of 2008. Do we really think that demand increased sufficiently to drive the price of the market up by a factor of more than 1,000? Call me crazy, but I doubt it.
I suspect it has a lot more to do with the fact that the stock market represents a collection of companies, and (most of) those companies make money. That’s what businesses do.
To attribute long-term market results purely to increases in demand, rather than to the collective creative power of our entrepreneurs seems like a mistake.
And if active funds and stockpickers are only contributing to short-term movements (i.e., volatility) rather than adding significantly to long-term return, why on earth would index investors need them around?
Is there something I’m missing here? Something I’ve left out that gives this argument a little more weight?
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{ 7 comments… read them below or add one }
Let’s explore this topic over here
The stock price is “supposed” to represent future total earnings, but if you look at every stock (which has P/Es of more than one), it ultimately means we will pay for the future earnings.
With that said, the P/E is ALWAYS more than 1 so we will always pay for the future. With active managers, they end up creating more demand via liquidity and that causes more interest from other people as a better investment than alternatives (treasuries, real estate and whatever else) and hence more buying.
More buying = high stock prices even with the same earnings because the market at the end of the day about supply and demand (ie if there isn’t a single person that wants to buy the stock and no one owns any, the stock price will be bid down to $0 no matter what earnings it is)
Sure, active fund managers increase demand. I’m not doubting that. And that does, in fact, have an upward effect on stock prices overall.
What I’d argue, however, is that this isn’t necessarily a good thing for other investors. The more a person pays for an investment, the lower his rate of return will be on that investment.
In other words, lower demand is a positive thing for a significant group of investors (those who are still planning on buying more stocks).
Also, I really like your example of a stock price falling to zero. In the (clearly hypothetical) situation in which a stock price is $0 for a company that’s still earning money, investors would still be earning a non-zero rate of return. They’d still be earning dividends.
And, in fact, for anybody who buys the stock after it hits a price of $0, they’d have an infinite rate of return. ($x dividends / $0 share price = infinite rate of return.)
Permanently high stock prices (ie, a permanently high P/E ratio for the entire market) aren’t a good thing except for people who have already bought all the stocks they ever plan to buy. For every generation after them, permanently lower P/E ratios would provide better returns, right?
Anyone that thinks index funds NEED active traders is an idiot. Just look at any other investor channel other than the stock market for your answer.
Do VCs need investors to sell and buy every day? Do LLCs need high turnover to make their money? Do you need people to sell their CDs early to increase your return? No, No, and No. While traders do create short-term returns even for long-term investors, long term investors are only looking for a cut of actual earnings and long term appreciation of the company. High turnover trading has no bearing on these factors.
So yes, they play a role in the game, but they are not needed for long-term returns.
I agree with your comments Mike.
In the short-run, market action is ALL about supply and demand.
In the long-run, its ALL about earnings.
Nice discussion.
@MoneyNing
Yes, we pay for several years of earnings when we purchase a stock. But pretty much everyone everywhere is willing to do that for any asset that has earnings. Which explains why, years later when we sell our shares, we’ll find people willing to do exactly what we did. At that point we’ll get paid for several years of *current* earnings, so over the long haul our gains will be driven by earnings growth, Q.E.D.
Active traders are surely somewhat responsible for the volatility of P/E ratios, but those ratios stay in a pretty well-defined box – even if it’s big – and they travel the length of that box more than once in an ordinary person’s retirement investing horizon. There is nothing an individual investor can do to change that. But changing *earnings* moves the entire P/E box itself; it makes the company worth more at the same P/E ratio or even – over the long haul – at a smaller one. And those results are about the company, not the investor or his peers.
Slightly tongue-in-cheek, but if all those active fund managers had so much demand for the stocks in the index fund, wouldn’t the active fund become an index fund eventually?
Clearly, the active managers have to invest outside of (or at least in different proportions) than the index, or they wouldn’t be able to sell themselves on supposedly beating the index.
Ethan: You nailed it there. Thanks for contributing to the discussion.
Kevin: You bring up an interesting topic. Some financial authors (John Bogle and William Bernstein, at least) actually have a name for active fund managers whose investments are substantially identical to index funds. They call them “closet indexers,” and apparently they’re more common than one might guess.
And you’re absolutely right, they have no hope of beating the market. But they probably won’t get fired (at least not too quickly) because they’ll never have a year in which they underperform it by several percentage points.