A couple of years ago, shitting on the gigantic index funds was all the rage; Robin Wigglesworth at the FT even wrote an entire book about them: Trillions How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever.
In yesterday's Money Stuff, Matt Levine had some interesting takes.
In classic reductio ad absurdum he envisions what a stock market consisting only of index funds would look like. Prices wouldn't, um, change. If there are only index funds, and index funds hold a market-weighted basket of securities, the conclusion follows that stock prices are fixed:
roughly speaking, I think the idea would be that each company would have sort of a permanent stock price — set, I guess, by the last trade before the market went all-index? — and that stock price would not really change
But reality (cash flow of real, underlying business) doesn't, so insiders could "trade" using buyback or stock issuance:
A company would get some good news about its business, it would think “oh wow the present value of our future cash flows went up, but our stock price did not,” so it would buy back some stock because the stock is cheap. It would get some bad news, think “uh oh the present value of our future cash flows went down, but our stock price did not,” so it would sell stock because the stock is cheap. Private equity firms would take companies private when the market temporarily undervalued them, and take them public again when they could get an irrationally good price.
"This rebalancing approach successfully captures the market as it evolves, but effectively buys at high prices and sells at low prices."
but they might not actually be particularly good at capturing alpha...
My impression is that public companies tend to issue stock when they desperately need to, so the stock price is low, and they tend to buy back stock when everything is great, so the stock price is high. (That is: Companies sometimes do issuances and buybacks as price-based trades, but they more often do them for fundamental reasons with little price sensitivity.)
Pretty fun thought exercise, and the model/paper referred to looks cool as well (“Index Rebalancing and Stock Market Composition: Do Index Funds Incur Adverse Selection Costs?”). Result? Index funds drag down returns by a few hundred basis points.
Some financial-engineering type conversations about Bitcoin ETF and MSTR in there too. Well worth a read.
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