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Free Riding and Indexing

September 24, 2021

Free riders exist in any economy. It's not a great way to structure a system, never mind a society. It's generally considered an economic problem, in that certain individuals consume more than their fair share of a resource without cost.

In one sense, an index fund is a free rider. (1) The fund sits around and reallocates resources to the stocks or bonds in the market class, letting the active players in the industry do all of the heavy lifting, and take all of the expense, valuing the companies. Once the market capitalization changes on an individual stock, the index adjusts.

For example, in a lot of the towers in New York, asset managers spend time studying the details of businesses. Committees then meet. Everyone jokes around about how ridiculous Powerpoint is and then everyone dives into the Powerpoint presentation. Among a lot of blue dress shirts (hey, what's wrong with that!), theories get handed out that sound good and reasonable.

"Electric cars are consuming huge amounts of lithium in their batteries. This is going to drive the share of miners in Chile" or "I really think Saudi Arabia is going to have a water problem given that it's like 100 degrees and they have a lot of people and a lot of desert." To the people sitting in the meeting thinking about what show they're going to watch on Netflix tonight, these sound like reasonable thoughts and one person asks some questions to seem smart and then everyone agrees electric cars need lithium and desalination is important and the asset manager buys some shares.

An instant later, the index rolls in and says "Thanks for your hard work, we agree, let's do this. P.S. we're not paying you anything for your research."

But then across the street in New York, one floor down but close enough that you can kind of see the meeting across the street when the lights are on, there is another asset manager presentation. And this woman is saying "Look, I think everyone knows that we need a lot of lithium and that is all priced in already. And Bill Gates has been a bit distracted recently because his PR machine fell apart, but still, he's a smart guy and he's got all these investments in new battery technologies and they don't need to haul stuff out of the ground in Chile, somehow get it on a boat to the U.S. when there aren't any boats available, and so I think we should sell those miners." And the committee agrees and they sell.

And an instant later, the index says "You are also correct, that was an excellent point! An instant ago the world had not considered that. So we're right behind you, selling. And oh, once again, no fee."

Note that, if indexing got too big, an economic problem would set in from this free riding, as there would be no one to price the securities. But I doubt that is going to be a problem, given human behavior and the enticing incentive of playing the stock market.

Dan Cunningham

1. I said "In one sense" because it's not a foregone conclusion that an index fund is a free rider. Here's a counter-thought. If indexing is pulling smart financial people away from active management, that could be making active management easier. Perhaps active management's primary problem is that they have too many smart people competing. See this Morningstar article for more discussion.


Back to school: breaking down an index fund

September 3, 2021

It's time to buckle down and get serious. Kids are back at school; we adults need to focus on the basics.

First, some homework. Let's deconstruct an index fund, and look at why this investment instrument works. You need to read this new article that we wrote and diagrammed. It explains the under-the-hood mechanics:

https://www.onedayinjuly.com/index-fund-investing


Some observations are in order.

1. Notice that the index has a "spread your bets" approach. It is acting like a large venture capitalist. Years ago venture capitalists learned the advantage of size. No matter how much they study a firm or industry, random probability plays a part in whether they hit a big winner. Because the upside of a win is so large, it makes sense to gain exposure to many bets.

This is what the index is doing on a less extreme scale. Despite the fact that most stocks turn out to be at best yawners and at worse worthless, the index is searching for exposure to the big winners to offset everything else. It searches by diversifying widely.

2. Good index investors watch fund construction for tax reasons. The index fund industry is getting better here in general, and they were already good. Under the hood of the index fund, managers are swapping positions to minimize tax exposure. You can read about one of these techniques, called heartbeat trades, here.

3. Indexes create good investment behavior. This year, indexes have been pushed out of the news by stock trading hype. That's fine. Look, if you're locked in your college dorm room and you already dominate the record board on Grand Theft Auto, maybe trading some stocks on an app is a good idea. The market went on a tear over the past year, and because you're probably not controlling for baseline performance or worrying about all those capital gains tax bills your trading will create in April, you feel pretty smart. But what you have done is taught yourself some very bad habits. On the other hand, indexing builds habits of patience, humility toward the market, tax awareness, and reduced financial media consumption.

4. Stick with market-cap weighted index funds. On the equity side we generally use index funds that reflect the market capitalization of their underlying stocks. There are lots of other flavors, such as index funds that weight based on profitability of the underlying firms. You might think "Well, that makes sense, if the firm is more profitable it should get a higher weighting." But that's only one variable in an enormously complex equation that millions of people around the world work on every day, and the market capitalization is the final reflection of their collective opinions. Feeding the market capitalization into the index captures the broadest scope of known information.

Dan Cunningham


Space Rocketeers and Creation of Industries

August 13, 2021

It's a bizarre summer when Elon Musk looks sedate.

He's the third leg of the billionaire rocketeer trio, and the only one who did not strap himself to 10,000 pounds of liquid hydrogen for his summer vacation.

Jeff Bezos did, and the trip went well! There were some odd moments for viewers. For three minutes as he soared parabolically, millions of Amazon shareholders probably wondered how their kids' college educations became tied to a laughing guy over the Karman Line. But he survived and the ship came down both alright and upright.

That's when it got weird. Bezos emerged from the capsule and gave a speech thanking Amazon's customers for funding his summer travels. Amazon's customers wondered why they just didn't get lower prices (1). And then after emitting lots of nitrous oxide (though in fairness no carbon from that engine) he professed the environmental advantages of spaceflight, citing the need to move heavy industry off earth. People started to wonder whether the champagne had been uncorked mid-flight.

This was an extreme, and public, example of how new industries start. The entrepreneur tests unusual concepts, and the foreignness of those concepts stirs up significant negativity. People have trouble seeing that the entry experiment is not the end goal. The early days of the industry seem wasteful.

An industry with an exponential curve underpinning its economics will deliver results no one expects - the human mind struggles with exponentials. For example, the rapidly declining cost of computing power or solar energy, based on silicon, created tremendous industrial upheaval. (Until Facebook showed up most people probably thought for the better.) The space billionaires are betting the same thing is going to happen: the costs will plunge as propulsion systems improve, drawing more people and ideas, good and bad, into the business. Over time, moving heavy industry to the cosmos doesn't seem quite as whacky.

The movement along the innovation curve is already happening. Here in Burlington, Vermont, people are employed building micro-satellites. They get those satellites to orbit by going onto the SpaceX website and ordering launch time. Like ordering a cheeseburger on a menu, but it's a spaceflight!

And then there are the positive side effects no one can measure. One of my daughters stopped tracking the Tesla automobile Elon previously shot into space and started researching the SpaceX moon rocket, so that was an improvement from a parenting perspective. Millions of kids wonder if they can be an engineer too, or at the very least invent a scheme to get their summer vacation paid for. It's impossible to measure the long-term inspirational effects.

It takes some times for new industries to influence index funds. But this is how they're born.

Dan Cunningham

1. I need to address this. The wealth for Blue Origin came from Amazon, and Amazon built that wealth in part by lowering prices for customers. Amazon's growth was slowing in the early 2000's until they began a relentless program of cutting prices. Customers loved it and rewarded them. It's important business-wise and society-wise to understand the difference between an income statement and a balance sheet. Amazon used thin margins on its income statement to earn a massive balance sheet. More on this later.

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