If everyone used index funds...

[Duck Rabbit]

I've seen the data provide by ifa that passive index investing will outperform something like 97% of actively managed funds. What would happen if every investor in the world looked at this data and decided that they ought to move their investments to index funds. If all the money in the stock market were in passively managed index funds (let's just say an S&P 500 fund), wouldn't every stock in that index move exactly the same percentage per day, per month, per year, etc.? If this is true, what implications would this have for the overall long term performance and fluctuations of the stock market?

[kimchi]

Despite the compelling evidence in that website, relatively few people use passive investing - and even fewer outside The US. People have a need to 'beat the market' and yet ironically, this need almost always results in them lagging the market - often significantly.

The market can be beaten by choosing funds and managers very carefully, but very few investors have the time or knowledge to achieve this.

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If all the money in the stock market were in passively managed index funds (let's just say an S&P 500 fund), wouldn't every stock in that index move exactly the same percentage per day, per month, per year, etc.?

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retirement funds and retail investment makes up a proprtion of the stockmarket investment, but I've no idea how much. Not everyone is an investor. There are traders, hedgers, people with stock options, and other holders who would affect prices regardless of whether or not everybody invested in index funds.

[Fishhead24]

kimchi is fast becomeing known as an intelligent poster in this forum.

[Newt_Buggs]

index funds do create somewhat of a "free rider" problem where by buying index funds you are benefiting from all fund managers and other active investors without paying any fees. All of those other investors with money in mutual and hedge funds are paying the managers to trade equities and make the market efficient. You can then benefit from the efficient market that all of the managers have created by just buying an index fund, but the index fund bypasses their fees.

If enough people switched from some form of active management to passive management then the market would eventually become less efficient, but that would then allow people to profit more from active management which would correct those inneficiencies, thus causing people to swith back from passive investing to active investing.

I hope I'm not totally wrong on all of that.

[T50_Omaha8]

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If enough people switched from some form of active management to passive management then the market would eventually become less efficient, but that would then allow people to profit more from active management which would correct those inneficiencies, thus causing people to swith back from passive investing to active investing.


[/ QUOTE ] This is essentially right.

As the number of active investors increase, a state of arbitrage develops, resulting in a situation where you might as well just invest in index funds. If everyone invested in index funds, the markets would be nowhere near a state of arbitrage, giving a free opportunity to any active investor.

Theoretically, it wouldn't even require a very large number of investors to actively manage their portfolios in order for efficient pricing to occur. Individual investors can just keep buying/selling securities until they are properly priced.

Sometimes, active investmentors can even detract from market efficiency. I have read that when Jim Cramer gives a stock pick, its price rises quickly at first and then slows down in comparison to the rest of the market, until the true value is once again reflected in the price. This creates an arbitrage opportunity, whereby short sellers can sell a picked stock short and use the cash proceeds to buy index funds, which will push the stock's price back in line with its value.

Joe America is the person who gets screwed in this particular instance, while the index investor is completely indifferent.