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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
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.
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.
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).
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
tracking corporate actions for the index constituents. Fin.
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
I just realized that @bauhiniacapital wrote about this way more eloquently and also ~5 hours earlier here —https://twitter.com/bauhiniacapital/status/1359919232062873603 …
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 …
Interesting, could you elaborate a bit? So if one component rises and becomes a larger part of the index, are you saying, the fund doesn't have to buy more, bc it already owned that component, and when it rises, the funds' exposure to it rises too, so no need 2 adjust?
Yes, this is exactly correct!
Knowing nothing about this, but having listened to a lot of @profplum99, when you say "track the index", what does this mean? Let's take VTI (Vanguard Total Stock Market) - I put $100 into VTI: what does Vanguard do w/that money? How is it spent?
They buy all the stocks in the index in proportion to their weight.
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