The Growing Popularity of Index Funds and Higher Stock Valuations

bogleonmfI recently read (and re-read) a post at Philosophical Economics titled Diversification, Adaptation, and Stock Market Valuation, which serves both as an educational resource and an interesting argument for a new shift in stock investing. It’s rather lengthy and not written for novices, but it doesn’t require a finance or math degree either. I recommend reading it in full, but here are my notes.

#1 Diversification is good. Buying a single stock exposes you to the risk of your investment going to zero. Lots of companies have gone to zero. For a long-time, most people either bought individual stocks or bought funds that owned a limited number of individuals stocks. High risk leads to lower valuations and thus higher expected returns.

Buying a diversified basket of stocks provides good returns with greatly minimized risk of permanent capital loss. Here’s the dividend history of the S&P 500 from 1926-2016, adjusted for inflation:

indexrise2

#2 People are realizing that diversification is good. When Jack Bogle published Bogle on Mutual Funds in 1993, Vanguard was considered a big success after reaching $100 billion in assets. (I recently bought a first edition for my collection.) Today, Vanguard manages over $4 trillion in assets. Yes, 40 times as much.

In 2000, under 10% of asset were in index funds. Today, roughly 25% of the US stock market is now held in index funds with no signs of retreat. Nearly everyone has the ability to buy a basket of 500 to 3,000 stocks for just $5 a year per $10,000 invested.

indexrise

#3 We are also seeing higher average equity valuations. Correlation or causation? If everyone starts to agree that low-cost index funds (and “closet” index funds) makes investing less risky, then shouldn’t lower expected risk lead to higher valuations, and thus lower future expected returns? It won’t be a straight line, but it could be a powerful overall trend.

A couple of excerpts:

My argument here is that the ability to broadly diversify equity exposure in a cost-effective manner reduces the excess return that equities need to offer in order to be competitive with safer asset classes. In markets where such diversification is a ready option–for example, through low-cost indexing–valuations deserve to go higher. But that doesn’t mean that they actually will go higher.

To summarize: over time, markets have developed an improved understanding of the nature of long-term equity returns. They’ve evolved increasingly efficient mechanisms and methodologies through which to manage the inherent risks in equities. These improvements provide a basis for average equity valuations to increase, which is something that has clearly been happening.

Definitely food for thought.

Comments

  1. Less Risk = Less Reward

    I think the other thing to look at is as more money gets blindly thrown into index funds, there could be an argument made that active managers will start to offer more value. We’re not close to being there yet, but maybe some day.

  2. I came here to mostly echo Maury’s comment. I use to be an index fund absolutist, but everyone moving into index funds seems to be a huge contrarian indicator, at least until everyone starts getting fed up with index fund’s low returns and tries to beat the market again.

    I shifted to basically all Emerging Markets stocks for the past year to incredible results. And I still buy mostly index ETFs, but I place bets on methods of indexing that aren’t tied directly to market valuation.

    Obviously, this could be a fluke, and over the course of my life I may match or lose to a traditional mix of index funds, but it’s hard to worry from my current vantage point of being up 16.6% over the last year.

    • Frank B says:

      Isn’t the S&P 500 up more than 17% over the past 12 months? VTI has performed even better. That 16.6% gain isn’t looking so great when everything is up, and that is before taking into account your higher expenses and probably greater risk.

      • Mike H says:

        That was a very conservative back-of-the-envelope calculation based on some numbers on Vanguard. My main fun (PXH) is up 30% over the past year. I’m obviously not only in that one fund. I have a large portion in Foreign Developed Markets as well. My risk is somewhat higher than pure VTI, but that’s on purpose. One question is how much upside space is there left for US stock vs. Emerging Markets currently. Risk goes both ways, up and down.

  3. I totally agree with the Maury and mike Index are pretty much risky.

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