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Herb Blank's avatar

Dave, this is a brilliant and comprehensive analysis of the indexed investing world. I give a lot of thought to many of these issues.

In particular, I am convinced that specifically S&P 500 weekly/monthly cash flows in retirement/dollar-cost-averaging plans must mean that membership in the S&P 500, regardless of a securities weight creates a premium for that stock over similar stocks. Therefore, as S&P 500 index investing continues to gain market share, this premium would only grow.

Malkiel's point of wanting to own the entire market because all stocks in a market are structurally equal and prices move randomly was an argument I believed in throughout most of my investment career. I was an investor in Vanguard Total Market since 1989 and an investor in VTI since its inception.

I observed and wrote papers between 1980 - 2020 based on this presence. As one who has been involved in the chase for systematic "alpha-plus factors" throughout this span that I eventually surrendered, proving that some market factor led to above-average returns over some past period, only proves that it appeared in the time period measured.

Stock prices are determined by cash flows. Supply and demand. Period. If 30% of cash flows are directed proportionately into S&P 500 stocks, that represents a 0% allocation in that 30% to small cap stocks and stocks with other distinct "smart beta" characteristics that are not in the S&P 500. Therefore, to cancel this effect, the remainder of investors would need to allocate more their flows at a ratio of 1.4 to non-S&P stocks to 1 in order to counteract the S&P 500 effect. However, since most professional active managers are measured against the S&P 500 or a similar index, only those with small cap or other mandates could afford to "bet against" the structure of the market as their tracking errors as measured by consultants would be through the roof.

In other words, Dave, your concerns and focus on flows are right on time. Thanks again

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Elisabeth Kashner's avatar

Dave, thanks for sharing your thoughts on the unintended effects of increasing passives' market share. I had the pleasure of discussing Marco Sammon's "Who clears the Market" paper at the Four Corners spring meeting. The discussion was vibrant - and that's all that I will say under Chatham House rules.

One factor to add to your analysis - inherited IRA taxation. Under current tax law, heirs who inherit IRAs have ten years to draw them down. IRA distributions are taxable income. Therefore, many heirs will have to sell a portion of their IRA holdings to cover their tax bills.

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