Are index funds actually undermining the diversification they were there to create? Once again,...

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klarsolo Comments (683)
 
I do hope most financial "professionals" know that high correlation does not imply similar returns. If high correlation is their excuse for underperformance then that's pretty sad. You can use it as an excuse for elevated volatility, but not for shoddy performance.
18 Feb 2012, 09:44 AM Reply Like

Econdoc Comments (2944)
 
first of all - stocks are an asset class - other asset classes are commodities, property, bonds all of these classes have different risk return profiles

stocks can be split into foreign and US and within those classes they can be further split into emerging and developed and for the US into big and small. all these classes have slightly different risk return profiles

second - within stocks there are two types of risk - stock risk and market risk

you can reduce stock risk through diversification but you cannot eliminate market risk with an all stock portfolio

the point of diversification within a stock portfolio is to achieve a given return with less risk but you need to understand that stocks - all stocks - are highly correlated - they are the market - you don't magically eliminate that risk. if you want to reduce that you need to add other asset classes - preferably not stocks.

the point of diversifying with a variety of asset classes is the same.

a final point. you only get paid for risk. and one or even 5 or 10 years is too short a time frame to understand any of this - you want the longest time series you can get. if you use that you see that stocks do well and better than most if not all asset classes - but they are also highly risky.

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18 Feb 2012, 10:31 AM Reply Like

bold'un Comments (9)
 
It depends a lot on investment timeframes; for short term traders and arbitrageurs, high correlation is not good news; but for long term investors, the difference between SP500 and the Nikkei are marked to say the least; think weighing machines versus voting machines…
18 Feb 2012, 10:37 AM Reply Like

Ron Myers Comments (209)
 
What a poor article. Index funds have nothing to do with correlation. The cause is HFT which came around around the same time indexing really got popular. Legions of the brightest PhDs around spent their lives on models to instantly buy or sell any stock that falls too far away from its benchmark assets (unless there is actual news on the stock, where they turn the stat arb models off and the news reader models on). Now it is so competitive that profits from this style trade are very small but that doesn't stop people from doing it.

Note that this isn't the worst, because the reason these strategies have ever worked is that over long time periods assets across a given class tend to converge to the mean anyway. They are just reducing the time scale.
18 Feb 2012, 10:47 AM Reply Like

Windsun33 Comments (3924)
 
I agree with the author. The problem with index funds is that it includes all the trash fish as well as the lobsters and tuna's. When the entire index has heavy money moves in or out, every stock in the index is bought and sold, affecting the price of the stock. No matter how good or bad the basic company is.

If I buy $1,000,000 in the Acme Energy ETF, I may have gotten 23 shares of Exxon, but I may have also gotten 19 shares of Solyndra. Large influxes of cash into the broad ETF's can prop up garbage that no money manager would normally buy in a managed fund.
18 Feb 2012, 12:08 PM Reply Like

PCScipio Comments (204)
 
True. But even if you're clever enough to buy just the lobsters and tunas, you'll still be affected by the stupid fishermen who troll with the large index nets.
20 Feb 2012, 01:05 AM Reply Like