OT - Hi Christine, Yes - Daniel is clearly saying that the little guy is 'hitching a ride' by investing in the index. Let's leave that 'value judgement' aside and try to examine if the trend toward index investing is creating any evidence of the ill effects he describes. I think that if we can disprove the effects, we should be able to dismiss the very title of the article - that index investing is 'evil'...and further show that it's not harmful in any measurable way. We should also consider the enormous benefit to the consumer of the low overhead involved with index investing, and balance this obvious good against any perceived ill effects.
Where our good man loses the plot, in my opinion, is when he tries to extrapolate the concept of the 'little guy profiting from the work of the analysts' to measurable inefficiencies in the market. This must be our holy grail - are inefficiencies created?
Fact - no. Just ask Burton Malkiel of 'a random walk down wall st' - he knows lots more about it than me. But essentially, here's why:
I am an investment banker in a small country with 5 stocks. I have the ability, as does the general population, to invest in individual stocks or in the basket. I find that there are more and more people who are investing in the basket, without peering at the individual components (the essential premise Daniel gives us). I speak to each of these companies each week, and notice that a,b,c, and d are doing well, while e is beginning to show problems with production of its product. However, due to index investing, the stock of company e is currently up 10% Year-on-Year, just like the rest of the index.
Now if there was no such thing as leverage (the weapon which shreds Daniel's thesis), I would have no ability to exploit my information and force prices into line. Let us assume that each company has a $1m market cap, and all stocks are trading at $100. Without leverage, I could perhaps short company e and wait for the company's results to slowly encourage investors to shed 'e' due to a falling dividend.
However, I can bring the price of 'e' back into line TODAY if the bank will let me borrow a few $100k. In this case, which is like the position of the leveraged participants in the US market, I can go out and sell $200k worth of e, while buying $50k each of a,b,c, and d. the whole market might well not move, but I can guarantee you that the price of e will fall while a,b,c, and d will rise. I will keep selling e and buying the others UNTIL THE PERCEIVED VALUE GAP IS ELIMINATED. (not shouting...just emphasizing <ggg>) Over time, as the companies' dividends begin to diverge, I will realize the profits on my position. This assumes that I'm the only one who has the information - and it still works out that bad companies get sold and good ones get bought. Through 'arbitraging' my perception of the relative values of the companies with the leverage given to me by the capital markets, I can reap enormous rewards. After all, if the price of e falls 20% over time while the others rise 5% each, and I have only put up $40k margin with the bank to borrow the $400k, then I stand to make 50% to 100% of my initial stake through the application of my knowledge.
What is the result? I, as an investor with leverage and superior information, have the ability to force the markets to become 'efficient', regardless of the actions of the other participants.
Now in the real world, there are ten-thousands of people who have leverage and try to 'exploit' any 'inefficiencies' that the index-investing public should allow to emerge. So we have a natural balancing force in nature which forces price efficiency - each participant is optimizing his particular set of money and market knowledge to reach an efficient outcome.
It happens every day - and that's why the markets remain efficient.
Now - different topic: VISIBILITY and MOMENTUM create a higher valuation (on the aggregate). That's why big companies are valued more highly than small ones. Look at the PE's on the Russel vs. the S&P. No contest. But that's not because of index investing - it's because most money managers can only keep so many companies on their radar, and taking a $10m position is almost impossible in a company with a $40m market cap. This inefficiency partially results NOT from Index Investing (You can invest in Russel-linked funds), but from momentum investing in individual stocks...and stocks that are too small never make it to the Silicon Investor (or other) message boards...so they can never achieve the same stardom/overvaluation. In true indexing, and with less of an eye to momentum, investors would be buying the small-cap indexes as well as the stars, moving those values into line. So as we move away from 'stock picking' and move toward 'buying the whole market' through true, broad-based, indexing, the small caps would benefit. Currently, momentum favors the big guys. This too will change.
So small investors don't 'ride' the work of others - they balance arbitrageurs who 'live' from the index-investing public by redistributing capital. These opposing forces lead to an inevitably efficient outcome. Essentially, Daniel forgot about leverage. Leverage and momentum investing, not index investing, move MSFT. Index Investing is the 'tide that raises all boats' - evenly. Indeed, every SI investor using margin to trade stocks is a player in the 'value finding' process, and tries to beat the 'index investors'. There will never be a shortage of players on either side.
...that's how I see it anyway <ggg>. Interesting topic.
Have a good weekend!
j.o.
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