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I'm reading The Beginners Investing Book by Matthew Kratter and to quote him directly:

In the old days, very few people practiced indexing. That guaranteed that it would provide pretty good returns. These days, anywhere from 50-70% of the money in the stock market is tied to indexing. This almost certainly ensures that investment returns will not be as good in the future as they have been in the past.

My question is why is this?

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  • 21
    What reasons does the author give to support this claim?
    – Hart CO
    Aug 29 at 16:15
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    Vote to leave open with my slight edit to the question title. I like the way this question and answer from @timday exposes hidden motives in "professional" investment advice.
    – Rocky
    Aug 29 at 16:31
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    @HartCO he did not elaborate, so I asked here
    – Linkin
    Aug 31 at 6:38

6 Answers 6

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Though Mr. Kratter does appear to have a financial incentive to suggest that index funds are likely to underperform going forward, he is also making a legitimate criticism of index investing.

The market depends on a certain number of investors analyzing companies in order to discover the "efficient" price (i.e. the price that fairly takes into account everything publicly known about the company). Index investors are free riding on that effort. The more money that goes into index funds, the more likely there will be inefficiencies in market prices that active traders could exploit to get better returns than the index fund.

Imagine, for example, that first thing this morning, every investor put 100% of their money into broad-based index funds and all active trading stopped. Apple today comprises ~7.35% of the S&P 500 index so someone buying the S&P 500 index would be putting 7.35% of that inflow into Apple regardless of the fundamentals of the company. If Apple announced tomorrow that every iPhone in the world was going to explode at the end of the month, its price would likely still rise because it is a large part of most broad-based indexes. There would be no active investors to force the price lower in response to this terrible news.

Though this is a legitimate theory, in practice, it appears that there are more than enough active investors in the market to ensure that prices remain reasonably efficient. If index investors are creating price distortions, you'd expect that managers of active mutual funds would be able to identify and exploit these inefficiencies and would beat the index. To date, there is little evidence that active mutual funds as a class are regularly beating their index. If the percentage of passive investors rise and there are several years in a row that, say, 60 or 70% of active funds beat their index after fees, one might reasonably conclude that the tipping point has been found.

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    Great answer. I might propose that once the tipping point has been found, that people will start leaving index funds to pursue active funds, which would quickly swing it back the other way, leading to a perpetual oscillation between active funds being better and not better.
    – TTT
    Aug 29 at 19:34
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    Then someone's going to invent a "swing fund" to go between the two and sell that.
    – Nelson
    Aug 30 at 3:23
  • @Nobody it explains the rationale for the claim without necessarily endorsing it as being right. In fact the last paragraph in the answer makes it clear that this is not, in practice, something to be concerned about. I'm not sure what more you could expect.
    – Aubreal
    Aug 30 at 14:29
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    Minor quibble. It's not really about the percentage of the market that is actively investing, but the raw number of actual active investors. The population of active investors needs to be of a large enough size to perform it's function of removing inefficiencies. If for example every non-investor on the planet (lets estimate this at 3 billion people) decided to invest a large enough volume of money to swing index funds to be 95% of the market, it hasn't changed the population of active investors who can find and exploit the inefficiencies. Otherwise excellent answer.
    – illustro
    Aug 31 at 9:03
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    @TTT good point. Funny enough, a competitive market (about markets, how meta!) will form, where the hypothetically higher returns on actively managed funds would actually make them justify their ludicrously high management fees, until you hit a new equilibrium. The market might converge on high fee, high return active funds, and low fee index funds with relatively lower returns, but with both having equal profitability
    – Alexander
    Aug 31 at 9:11
43

Googling "Matthew Kratter", and the first result is a "Trader University", with text:

Hi there! My name is Matthew Kratter. I am the founder of Trader University, and the best-selling author of multiple books on trading and investing.

There you go; that's your answer. Mr Kratter clearly has an interest in persuading people that indexing doesn't work any more, with the implication that they should buy his books and sign up for his courses or whatever and learn how to be active traders, and so that's why he claims indexing won't work.

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    While I love a good ad hominem, this only discredits someone, it does little to refute the claim. Aug 30 at 6:01
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    Technically the question was why the author makes this claim, and addressing the author's motivation for making the claim is just as responsive as addressing evidence or reasoning. OP could have asked "is this true, and if so why," but chose not to.
    – Useless
    Aug 30 at 11:56
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    @Useless While you could interpret the question that way, I think their "why" is asking for the reasons the author believes it, not just the reason they're saying it. Read the last line of the question, not just the title.
    – Barmar
    Aug 30 at 15:21
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“Prediction,” goes an old Danish proverb, “is hazardous, especially about the future.”

This sentiment has been attributed to a number of people, among them, Niels Bohr, the Nobel laureate in Physics and father of the atomic model.

Predictions that rely on trends to continue indefinitely often run into comical results. For example, I was watching a presentation regarding cell phone sales at a time when these phones were the bricks seen in the original Wall Street movie. Exponential growth out indefinitely. I raised my hand and pointed out that growth of new technology has to be asymptotic to population growth. Any model that suggests say 50 billion phones will be sold each year to a population of 10 billion people makes no sense. You see my point.

On the internet, especially social media, anyone can say anything. This is true of books as well. Just because it's in writing doesn't make it true. A search on how much of investing is indexed results in about 16%. If the source isn't reputable enough, a dozen results were in a tight range around that number. (Ad hominem attack alert) When an author's conclusion is based on such an incorrect premise (50-70%?) I'm not likely to continue reading. As I get older, my own time is too valuable.

If I were writing my own article, I'd suggest 15-20% as a reasonable range. Considering that Jack Bogle devised the index fund in 1975, nearly 50 years ago, I'd say that we are quite far from a time when the phenomenon your author suggests is likely to happen. We still have 6,680 actively managed mutual funds along with all the investors who buy individual stocks.

One last thought - The 10-year average return for large cap stock funds (active management) ending 2012 was 14.96% vs the S&P 16.58%. After fees, I get 16.56%. More than a 1.5% difference. Justin gave an excellent answer to the hypothetical "what if everyone indexed?" but the fact is simple. We are not on a path where I'd concern myself with this.

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    Was Yogi Berra an ancient Dane? ling.upenn.edu/~beatrice/humor/yogi-berra.html
    – Barmar
    Aug 30 at 15:23
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    Get the iPhone and Galaxy franchises to release new models at a 6 month cadence and account for those who have both a personal and work phone as well as those who routinely break their screens or drop the phone in the toilet and getting 500% sales to the population isn't entirely unreasonable </g>. Also, I sincerely hope the e in Justine is a reference to Monica, as your sig may suggest.
    – psaxton
    Aug 30 at 19:30
  • Ha. Thx. I fixed the typo, apologies to Justin. Funny that we are now at 1.35 Billion sold in 2020 IIRC, I predicted growth to top out at some 1/2 of population implying most turnover would average a 2 year cycle. Aug 31 at 1:53
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As many others have pointed out, the auther has his own interest in promoting active management. He does this by being (probably deliberately) imprecise. While index funds certainly have the potential to impact price discovery, I am missing the important distinction between assets in index funds and trading volume. Prices are determined by trading and if trading stops because everyone is just buying up an index fund as in the example of Justin Cave's answer, this will certainly be an issue. Index funds are estimated to cause less than 5% of stock trading volume (source: Blackrock) which in turn means that more than 95% of trading volume is done by active investors. Any obvious mispricing is unlikely to persist if basically all the trading volume is still there.

Remember, it is not the 30 year period buy-and-hold investor that makes prices in a market. It is the short-term trader that actually makes a market by actually buying and selling.

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The author may be referring the concept of the index fund premium. This is the idea that when a stock is added to an index, index funds go out and buy it, giving it a price bump that is not related to its fundamentals.

For additions to the S&P 500 and Russell 2000, we find that the price impact from announcement to effective day has averaged + 8.8% and + 4.7%, respectively, and −15.1% and −4.6% for deletions.

https://www.sciencedirect.com/science/article/abs/pii/S0927539810000745

This means that as you are paying a higher price for the same return, your return as a percentage of capital is lower. Furthermore, if stocks are moved on and off an index, an index fund will buy stocks at a artificially higher price, and then, when a stock is removed, sell it at the natural lower price, incurring losses.

The conclusion "This almost certainly ensures that investment returns will not be as good in the future as they have been in the past," however, is a bit overreaching. It's well within the realm of possibility that the stocks in the indices could experience growth that exceeds the index premium (the Efficient Market Hypothesis predicts that such an event would not be expected, but that doesn't mean that a random walk could not have that result).

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If you invest in an index fund, most of your money gets invested in mediocre companies. Warren Buffett points out here that the best results are obtained by investing in a few strong companies. A diversified portfolio of stocks of a few dozen companies will usually already be suboptimal, let alone an investment in an index fund.

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    The problem is that it is impossible for everyone to "invest in a few strong companies". Scenario 1: everyone can reliably tell which companies are "strong". Result: their stock prices are inflated until they are ridiculously overvalued and you have to start looking at mediocre companies. Scenario 2: Nobody can really tell. Result: everyone invests in diffent "strong" companies, and most of them are wrong. Scenario 3: you know better than everyone else. Result: you eventually end up directing so much capital and so many people follow your trades that you basically end up in Scenario 1. Aug 30 at 13:46
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    This doesn't at all address the question of whether more people buying index funds makes them perform worse. Aug 30 at 14:12
  • @MichaelBorgwardt In Scenario 1 the stock prices will get only moderately overvalued, this is an effect that is clearly visible in the stock market. Shares of strong companies are a bit more expensive when measured by e.g. P/E ratio. They don't get "ridiculously overvalued" , because the stock market is very dynamic with a huge amount of short term trading on time scales of seconds to hours going on. Strong companies with good long term growth prospects are stable companies while short-term traders exploit news that cause stock prices to jump up rapidly or nosedive. Aug 31 at 5:47
  • @MichaelBorgwardt So, it's the short-term trading that is competing with long-term investing. If you put all your money in strong companies, that will give you a long term return in excess of index funds, then you don't have the money available to earn from the daily market fluctuations. Take e.g. last Friday. It was quite easy to make a lot of money, the stock market was sliding downward in steady way, so it was not really a risky gamble. There are many such slam-dunk opportunities during a year, you can make a large amount of money exploiting these. Aug 31 at 6:02
  • @NuclearHoagie The text quoted by the OP doesn't make that claim. Aug 31 at 6:03

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