Index Funds Promise Something For Nothing

I noticed recently that from 2008 to 2013, Berkshire Hathaway returned less than the S&P 500 Index.  This is a novelty.  The old standard for Berkshire was that over any 5-year period they would outperform the index.  Had the chairman lost his touch?

Maybe, but not certainly.

Buffett claims you need two skills to be a successful investor.

  1. A way to value businesses,
  2. An understanding of how the market prices stocks.

Business valuation is fairly well known and to some extent, the valuations and the techniques match the investor’s goals.

The market creates price a little like an auction.  At one time it was exactly that.  The price is what a willing buyer is willing to pay a willing seller.  The price is their instant assessment of what a security is worth.  To them.  Their motivation is part of the price but not part of the information endemic to the stock.  Certainly not part of business valuation.

In the next instant the price could be different.  Willing buyer and slightly less enthusiastic vendor makes the price go up slightly.  If there is an imbalance of buyers and sellers, there can be quite wide price changes.  The price that results is the amalgam of the enthusiasm of both parties together with what they believe about the stock.

That price may have some basis in how each sees the prospects for the business that issued  the security, but that connection could be entirely circumstantial. Even after the fact. Emotion always trumps reason.

Which brings us to one of the reasons the S&P 500 can beat Berkshire.

Index funds are fashionable.  Many people, including Buffett, recommend them as a good way to invest.  People follow that advice and money pours into index funds.  Index fund assets have more than doubled in the past 15 years.  Do you see the problem?  It relates to where prices, and therefore the index value, come from.

Index funds distort the demand side of the market.

Index fund managers buy stocks with their new money, but they only buy ones in the index and weighted by the way the index is created.  These buys create demand and that demand drives prices up.  As index funds seem to do comparatively well, more money flows in and the price rises some more. Nothing to do with value. 

Index funds are not infinitely scalable.  What will happen once they own 100% of the stocks in the index?  Where would the prices come from then?  Before the the float will get thinner and thinner.  That moves prices based on fund flows not depending on business, economic or other factors that should create prices.  Volatility follows. 

Index funds, by their incestuous price setting flaw will always be valued too high.  That must create some problems.  I know too little to be wise on this point, but one thing I do see is that index fund managers need know nothing about business values.  The index is price only.   Managers need know just the symbol and the weighting in the index.  The name of the business and its prospects are unnecessary.  Even confusing.

I wonder if Berkshire trailed the S&P only because of index price inflation.  What would the index value be if Berkshire had its normal relationship?  Someone with the numbers could say there is a structural bonus built into the S&P 500 of some amount assuming Berkshire behaved relatively as before.

What would it mean once it is discovered?

I suppose some index funds don’t actually buy stocks but instead hold cash and use derivatives to mimic the return.  I have no idea how that influences the argument, but even Buffett worries about derivatives.  Another layer of complexity at least.

Index funds need know nothing about business.  The idea of an index fund outperforming managed funds includes an element of something for nothing.  Historically, something for nothing does not last.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  866-285-7772

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