This is not true! A really basic cap-weighted index fund mechanic is that they automatically track the index as prices move, with no trading required. This is literally the reason that they are called *passive* funds.
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A wrong belief that many otherwise smart people have is that index funds are “momentum investors” i.e. they mechanically buy more as prices rise and sell when prices fall (example from Bill Ackman’s 2015 investor letter below and I saw this *twice* in unrelated threads today).pic.twitter.com/rntUJjob2V
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For some reason this breaks people’s intuitions and they get really excited about forced buying/selling from passive funds creating positive/negative feedback loops, which, I cannot emphasise enough, is not a thing that actually happens except in retail brain fantasies.
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Index funds do need to trade, but only on a few specific events - mainly index adds/deletes and corporate actions (e.g. new issuance, buybacks, mergers and acquisitions).
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There’s a whole exciting thread about *index rebalance* trades which I hope to write about one day but that is entirely separate to the day to say mechanics of index fund management, which is largely very boring and consists of making sure you are correctly
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tracking corporate actions for the index constituents. Fin.
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An important addendum is that index funds also trade when they have inflows and outflows (or an AP trades on behalf of an ETF using the create/redeem mechanism). This is important but orthogonal to the main point, which is that index funds basically never trade on price alone
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I just realized that
@bauhiniacapital wrote about this way more eloquently and also ~5 hours earlier here —https://twitter.com/bauhiniacapital/status/1359919232062873603 …Show this thread -
This thread is a great example of the incredible broken brain gymnastics that people will perform to to misunderstand how index funds work and how they impact prices. Not matter how hard I try to explain it, he keeps repeating the same meaningless point I give up! https://twitter.com/whirlybard/status/1360334892236607489 …
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End of conversation
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Isn’t the point that they carry momentum as investors dca in? But yeah completely agree. Indices are naturally balanced.
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I thought it was hedge funds, hft and retail trader on the agenda of market commentators ready to enlighted us with explanations, now index funds as well. thanks for bringing some common sense into the debate
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