The Smart Indexes Are Even Worse Than The Dumb Ones*

You may have heard that the Dow hit 13,000 today before subsiding to a shameful 12,965.69. You may not have heard this, or cared, because the Dow is for morons, being a price-weighted index of thirty semi-random companies that, gah, aren't even "industrial" any more.** There are alternative theories but those theories are wrong: Joe Weisenthal in defense of the Dow has been noting its very high correlation with other, broader, more sensible indexes. I see this as further undermining the Dow's legitimacy. If it's very different methodology were leading to some kind of meaningfully different result, then we could perhaps argue that it's adding value in some kind of way. But instead what's going on is that the Dow's creators are hand-picking which stocks to include in the index specifically with an eye toward constructing an index that mirrors the other, better indexes out there. Apple and Google, for example, aren't in the Dow and aren't doing to get in any time soon because their very high share prices would skew the index in weird ways. This just goes to show that the Dow's creators already "know" the right answer (from looking at the S&P 500 and the Wilshire 5000) and then are trying to assemble an index to create the predetermined result. Maybe! An alternative theory is maybe suggested by [Occam's razor and] this piece from the Journal this weekend about index funds that I just loved and so am now going to inflict on you at unnecessary length:
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You may have heard that the Dow hit 13,000 today before subsiding to a shameful 12,965.69. You may not have heard this, or cared, because the Dow is for morons, being a price-weighted index of thirty semi-random companies that, gah, aren't even "industrial" any more.** There are alternative theories but those theories are wrong:

Joe Weisenthal in defense of the Dow has been noting its very high correlation with other, broader, more sensible indexes. I see this as further undermining the Dow's legitimacy. If it's very different methodology were leading to some kind of meaningfully different result, then we could perhaps argue that it's adding value in some kind of way. But instead what's going on is that the Dow's creators are hand-picking which stocks to include in the index specifically with an eye toward constructing an index that mirrors the other, better indexes out there. Apple and Google, for example, aren't in the Dow and aren't doing to get in any time soon because their very high share prices would skew the index in weird ways. This just goes to show that the Dow's creators already "know" the right answer (from looking at the S&P 500 and the Wilshire 5000) and then are trying to assemble an index to create the predetermined result.

Maybe! An alternative theory is maybe suggested by [Occam's razor and] this piece from the Journal this weekend about index funds that I just loved and so am now going to inflict on you at unnecessary length:

Recently, leading investing experts—including Rodney Sullivan, editor of the Financial Analysts Journal, consultant James Xiong of Morningstar Investment Management and Jeffrey Wurgler, a finance professor at New York University—have been warning that index funds could destabilize the financial markets. ...

Today, according to Morningstar, 336 index funds and 1,148 ETFs hold $1.24 trillion, or fully one-third of all the money in U.S. stock funds.

That worries some analysts. "Markets work best when people think and act independently, not all together," Mr. Sullivan says. When investors add money to an index fund, it generally will buy every security in the market that it tracks—hundreds, sometimes thousands at a time, regardless of price. When investors pull money out, the index fund has to sell across the board.

"These index-trading behaviors," Mr. Sullivan says, "could interact with some unexpected event to cause significant and outsize consequences."

When I think about the things that are probably important in the world this one comes up from time to time. It's interesting in part because it's structural - there's a prisoners'-dilemma quality to it in that, for you personally, no matter what everyone else does, you should index***, but if everyone in fact follows that dominant strategy then we're all screwed. And I think that the guys cited by the Journal - and linked, go read their papers, they're interesting - actually understate the extent of that screwing. Yes if everyone indexes then correlations go up and, yeah, sure, I'll buy that vol, or at least tail risk, goes up too because the herd movements will exacerbate panics and make flights to safety more extreme.

But the main problem with super-efficient financialization can't really be that it will lead to more vol in your super-efficient financial products. I'd worry about something else: that the problem with a large and increasing proportion of our financial capital being allocated blindly and without any evaluation of the business prospects of the companies getting money might be ... that that system will be bad at picking the right businesses to finance.

The goofiest part of the Journal article is what to do about it. To be fair this is for individual investors but the gist is: go beyond the S&P 500 to invest in like the Wilshire 3000, international stock markets, and of course:

Bond index funds, even at today's paltry yields and lower returns, can still buffer the risks. "One thing hasn't gone away at all," Mr. Sullivan says. "Bonds will still provide padding for uncertain events and times."

What could possibly go wrong? I mean, this struck a nerve with me because it's what I do, and is the obvious advice for anyone who is financially literate but not going to go around picking stocks and market timing: just fling your money at a pile of things that approximates the breakdown of world GDP and hope for the best. You, like, can't do worse than average with that approach. You can't do better than average either but you weren't going to anyway, particularly not after fees.

But eventually someone is going to design a product for people like me who don't want to have to buy US and world and bond index funds and rebalance them periodically. That product will just be a market-notional-weighted index of all the financial products that you can buy in the world. And I'll buy that index. And that will be the end of my making any (ill-informed and mostly wrong) decisions about whether bonds are overpriced relative to equities or vice versa or whatever. As I've already ended - before it began - making any sorts of decisions about which companies are going to beat earnings estimates or whatever it is that companies do.

And maybe that's just me, but right now it looks more like it's me and 1/3 of the rest of the country. And that number is going up. We've mentioned before that elegant Interfluidity post about opacity and complexity in finance, which contains the lines:

Opacity is not something that can be reformed away, because it is essential to banks’ economic function of mobilizing the risk-bearing capacity of people who, if fully informed, wouldn’t bear the risk. Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper. Insufficient economic risks are taken to sustain growth and development. You can have opacity and an industrial economy, or you can have transparency and herd goats.

I have my doubts. One reason to doubt is that there are lots of people employed as capital allocators whose business it is to get to the bottom of opacity, understand the risks of a project, and then make a call about whether it has a sufficiently high NPV to finance. Those guys are getting increasingly swamped by high correlations and indexed investing. But it's hard to see how indexing could replace them.

Simple Index Funds May Be Complicating the Markets [WSJ]
Hedge funds ‘have to try harder’ [FT]

* Indices. I prefer "indices." But what are you gonna do.

** Really, just, gah. Price weighting I can deal with because it's a nostalgic Jesse Livermore throwback to when common stocks had a $100 par value and were supposed to trade roughly at par, and as an antiquarian I think that's kind of cool. But - as a very literal-minded antiquarian - it drives me nuts that the "Dow Jones Transportation Average" has, like, a bunch of transportation companies, while the "Dow Jones Industrial Average" has, like, BofA. What are they manufacturing? Don't answer that.

*** Or, fine, be really f'ing good at picking stocks, I don't care, do that.

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