Berkshire Hathaway
One Other Overlooked Aspect of Indexing

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By JimiH3ndrix
May 11, 2001

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I am one of those who solasis originally identifies as probably better off dollar-cost-averaging into an index-equivalent, because I don't believe I possess either the skills or the luck necessary to actively manage money in a way that suggests that I would beat an index, nor properly compensate my costs of time. Thus, this discussion has real meaning to me. I too have read through this thread twice, trying to wrestle with the market-cap weighting issue, and I want to say three things.

First, if Snoop is right that:

Mutual funds hold roughly half of the US market capitalization today, index funds just a fraction of that. Thus, even if for some reason that I don't understand your argument is solid, it's a non-issue today...

...then where is the problem? It would seem that for there to be a problem, the fraction of index funds would have to increase dramatically. I don't see that happening for a number of reasons, but mainly because most investors believe they are smarter than the next guy, and will continue to seek to beat indexes through active management (either independently, or through mutual funds). It would have to be a pretty persuasive argument that would convince me that a significant number of investors are going to fall in love with indexes for the problem to manifest.

Second, while indexes may be subject to temporary disequilibrium-cum-feedback-loops similar to those that gripped dot-coms at the end of the 90s, so what? If your time horizon is sufficiently long -- say for discussion purposes, 20+ years -- today's market-cap disequilibrium is going to be presumably overwhelmed by tomorrow's fundamentals since, as this board believes, fundamentals drive share prices over the long term. So, while your returns on the S&P may look gruesome today -- and for the sake of argument, let's assign all responsibility for such performance to the market cap issue -- they will be a distant memory and an itsy-bitsy blip 20+ years hence. As you dollar-cost-average through those years, presumably you will also benefit from periods when negative feedback loops, or barring that, negative investor sentiment, makes the index a rather handsome purchase. I can't see where it isn't probably a wash.

Yes, dollar-cost-averaging in an index through a period of mania probably does not represent "value investing." Further, when a couple of mega-caps dictate index-performance, you're probably also not immediately enjoying the benefits of diversification. But I would agree (hope?!) that TWA is right when he suggests, I wouldn't be surprised if 1999/2000 represents a 200 year anomaly in terms of "runaway indexing."

Third, TWA's replacement scenario went like this:

As indexes go up, investors get excited, and new money comes in. That new money has to buy Company A at $2. If it has to buy enough of it, the price will run up to $3. Which will attract more new money, leading to more demand for Company A's stock, leading to higher stock prices for company A. Now the active managers want a piece of it, and the price goes up to $4. And new index money has to buy it at $4, even though the value fund managers "know" it's only worth a buck.

And if company B continues to languish at $1, the mutual funds who own it outside of index funds will sell it to buy Company A. And the price goes to $0.50. Now the keepers of the keys to the Dow 30, S&P 500, or NASDAQ 100 want to replace it with Company C, or some dumb thing. More selling pressure on Company B, but Company C is on a tear now because of news it's about to be added to the index.

Wouldn't the "index-effect" associated with Company C be somewhat justified, since its cost of capital would presumably be diminished as a member of the index? That this may result in aggregate misallocation of capital, but again, so what? In fact, better than so what if you are an indexer, because the companies in which you passively invest enjoy lower costs of capital at the expense of those outside the index! With the currency of its "artificially" inflated stock, Company C can, perhaps, go out and make acquisitions, or consider secondary offerings, that were previously impossible. But doesn't that benefit me?

Trying to understand,