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ChristianKl comments on Open Thread, September 30 - October 6, 2013 - Less Wrong
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Comments (295)
Topic: Investing
There seems to be a consensus among people who know what they're talking about that the fees you pay on actively managed funds are a waste of money. But I saw some friends arguing about investing on Facebook, with one guy claiming that index funds are not actually the best way to go for diversified investing that does not waste any money on fees. Does anyone know if there is anything too this? More specifically, are Vanguard's funds really as cheap as advertised, or is there some catch to them?
The issue with an index fund that based on something like the SAP 500 is that the SAP 500 changes over time.
If a company loses their SAP 500 all the index funds that are based on the SAP 500 dump their stocks on the market. On average that's not going to be a good trade. The same goes for the trade of buying the companies that just made it into the SAP 500. On average you are going to lose some money to hedge funds or investment banks who take the other side on those trades.
In general you can expect that if you invest money into the stockmarket big powerful banks have some way to screw you. But they won't take all your money and index funds are still a good choice if you don't want to invest too much time thinking about investing.
This sounds like a sufficiently obvious failure mode that I'd be extremely surprised to learn that modern index funds operate this way, unless there's some worse downside that they would encounter if their stock allocation procedure was changed to not have that discontinuity.
They do because their promise is to match the index, not produce better returns.
Moreover, S&P500 is cap-weighted so even besides membership changes it is rebalanced (the weights of different stocks in the portfolio change) on a regular basis. That also leads to rather predictable trades by the indexers.
Being an index fund is fundamentally about changing your portfolio when the index changes. There no real way around it if you want to be an index fund.
If you could consistently make money by shorting stocks that are about to fall off an index, the advantage would arbitraged to oblivion.
The question is whether you know that the stocks are about to fall off the index before other market participants. If your high frequency trading algorithm is the first to know that a stock is about to fall off an index, than you make money with it.
Using the effect to make money isn't easy because it requires having information before other market participants. That doesn't change anything about whether the index funds on average lose money on trades to update their portfolio to index changes.