As always when articles like this come up, I want to issue the usual reminder to HN to beware of what pg called "submarine stories" (http://paulgraham.com/submarine.html). There are a lot of people who stand to lose a lot of money in fees if "just park it in index funds" becomes more popular advice than it is already. Not to say the analysis above is wrong, but just keep in mind (especially at the WSJ) that it may not be coming from sources with your best interest in mind.
"A report this past week from investment firm Sanford C. Bernstein, titled “The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism,” warned that..."
It would be funny if it wasn't so incredibly blatant.
>Because corporations know that, says Prof. Heemskerk, coziness and complacency may arise. “If you have only long-term investors, how do you keep management on their toes?” he asks. “Where are the checks and balances when you have such large block holdings?”
The whole system depends on the fact that investors have an interest in voting for a competent board and are willing to sell their shares if the company doesn't seem to be managed well. If the actual owners of the company aren't paying attention the opportunities for self-dealing and just plain incompetence on the part of company officers multiply.
Great point, I never had a word for it (thanks for the link) but I've felt this whenever reading the high-level economic stories about things like interest rates and the market slowing, etc. The cynic in me just assumes that whatever the author is saying will fail or whatever they're likely shorting.
When people wonder what would happen if index funds become too popular, I usually refer them to Warren Buffet's 2005 essay, 'How to minimize investment returns':
It is essentially a thought experiment about what would happen if everyone switched to one big index fund.
But, it glosses over the issue of individual security pricing and corporate management, which would become issues in a 100% pure index environment.
Of course, we won't ever get a 100% pure index environment, because the closer you approach it, the more incentive there is for active managers to exist.
I think what is really happening is that as more people use indexing, the less talented active managers are driven out of business. A small number of very talented active managers may eventually find themselves in a highly competitive market to exploit pricing inefficiencies, and they will end up incidentally providing management oversight and marginal pricing services to the indexers. These active managers will probably look more and more like private equity firms (taking an active hand in management), and less and less like traditional arms-length traders.
As long as this small number of talented firms isn't allowed to collude with each other, or self-deal unethically by controlling management, everything should be fine. In fact, having met some less talented active traders in person, I suspect that the quality of marginal pricing and managerial oversight may go _up_ as the number of active managers decreases, and the less informed and talented among them are eliminated.
> As long as this small number of talented firms isn't allowed to collude with each other, or self-deal unethically by controlling management
... and I've got a bridge to sell you.
More seriously though, the smaller the number of players, the more likely (and easy) collusion becomes. Successful cartels always have relatively few players.
This is very true. So many active managers are AUM businesses rather than alpha businesses. Long only funds which use bulge bracket banks as sales channel partners are particularly egregious.
One thing I like to point out whenever this kind of discussion comes up, is that there is no single index. Articles like this always seem to assume that everyone will buy the same index, namely the S&P 500 or total US market.
But that's not what a lot of index investors do. Indexers enjoy adding tilts to their portfolios. So some people will buy value funds, others will buy small cap funds, and yet others will buy small value funds. There are people who overweight certain sectors, like REITs or utilities. There are those who invest in international index funds (with all their variations) and those who don't. So there's a huge number of combinations you can think of when it comes to indexing.
Now, with people indexing like that, there would still be market liquidity. Maybe not as much as when there are single stocks being actively traded, but on any given day there will be people buying into different indexes, selling shares, or rebalancing.
Valuation would become troublesome though, but at least people would still get some return from dividends.
Plus everyone knows the S&P is a terrible benchmark because it excludes mid- and small-cap cos.
After watching mine from a far for ~7 years, I've come to accept that one really needs to invest in multiple index funds to get global diversification as well.
I guess this is a good place to ask: For someone who knows nothing about the market, what would be a good way to invest their money? From the responses here, I'm guessing "park them in an index fund", but is there a trustworthy company I can talk to that will do that?
That's a great point. I've always bought VTSMX, on the assumption that it's as close to "total US market" as one can get. Is anyone aware of downsides of VTSMX (excluding downsides of indexing in general)
Owning a few percent of a Fortune 500 company will probably get you a board seat, and a 10% stake probably makes you the single largest holder (especially ignoring companies still held by the founders/family like Wal-Mart or Google). Vanguard's current holdings makes them the single largest owner of Apple, Microsoft, and Exxon (the 3 largest companies in the S&P 500, I didn't check further). And that's just one of the firms offering index tracking ETFs.
Vanguard owning 6% of the entire US stock market value is huge. You could reasonably re-title this "Is Vanguard Eating the World" and be right if it wasn't for Blackrock and other ETF firms being close behind them.
It's a real book, but it doesn't prove the market is random, nothing does as the efficient market hypothesis is just that, an unproven hypothesis lacking even enough evidence to become a working theory.
That certain funds consistently beat the market year in and year out for decades is enough to disprove the notion that markets are random; they're not.
I think the argument is a little more complicated than that. It might not be enough to observe that active traders aren't outperforming the indexes, because, as the argument goes, passive indexing creates its own market forces that tend to favor incumbents and work against aspirants.
But maybe. Vanguard has 6%, Blackrock and Fidelity at 5% each, some of the other investment firms also offer index. I'll peg that all up, 45-50% of the investments are in some kind of index fund.
Lots of money and market push there as indexes.
Bogle said that there could be issues at the 90% level, so we are still pretty far away.
My issue is funds that are Index 500 or DJI average are set by someone else. Hence the huge number of funds that own Apple and can push on them. When they rebalances those indexes, it can be a traumatic event.
On the other hand, index funds are a way of playing par golf with your money every day.
"Yet Mr. Fraser-Jenkins has a point. Index funds don’t set prices; they only accept the prices that active investors have already set. If everyone owned index funds, he says, “no one would be doing” the job of figuring out what securities are worth."
The situation described is clearly not a Nash equilibrium. If you have special, accurate information on the price of a security, then you're going to act on it. Why would no one be doing the work of pricing something if it's profitable? Sounds like actively managed mutual funds are getting antsy because people are starting to realize that they're getting screwed not going with index funds.
If everyone invested exclusively in index funds, and no one works to establish a market price for each individual component, the obvious thing to do would be to adjust indices to manage the portfolio based upon actual dividends.
All companies converge on the same P/E ratio, and the ratio of the index depends on how much investor money is chasing the overall productive activity of every [investable] company in the economy.
It wouldn't be the end of the world, by far.
But it is doubtful this will ever get even close to happening, because some investors will always be gamblers at heart, and if they learn that Coca-Cola is releasing a new beverage flavor, they will use the financial markets to make bets on whether it will be insanely popular or a colossal failure.
FULL DISCLOSURE up front - I work in the index/ETF business. I help maintain ~75 indices, many of which have ETFs linked directly to them.
That being said, I fully believe there will always be active investors. As others have mentioned, if there is an opportunity to make money in the market due to something like passive index funds being slower on the uptake, it will be made.
If I had to interpret the core argument being made here, it is basically that there is a fear of a positive feedback type scenario where money keeps getting dumped into companies simply because it always has. But it can be highly profitable to beat out the slow, passive money by doing your due diligence. For this reason, active management will always exist.
Also, I am fortunate enough to work on some of the more complex and interesting products in the industry (at least I believe so, haha). I can tell you that there are definitely sanity checks put in place for this kind of scenario. Most of it revolves around fundamental ratios built into these product methodologies (i.e. P/E ratio must be within a rational range, company must produce stable income for the past 5 years, etc.). More importantly, securities in these portfolios are frequently weighted (at least in part) upon those fundamental ratios. So if a company starts to deteriorate, the size of the position in the fund will be decreased. Much of what the article talks about seems to be negated by this and becomes a non-issue. I think those arguments would apply more to benchmark products which don't have those kinds of requirements. Then again, many benchmarks are used for exactly that - benchmarking - and aren't directly invested in. There are, of course, indices like the S&P 500 that have significant sums of money attached to them, but they are the exception, not the rule. Most index products deemed "investment-grade" are STRATEGY based, not benchmark based.
Basically, there is room in the market for both. I think we are simply seeing the progression towards a new equilibrium, nothing more. That equilibrium is where the new balance of those willing to take a higher risk meet those that want the less risky, low cost products that we provide. There is simply a much smaller portion of the population willing to pay higher fees and have a larger risk (but with possibly greater reward). And that is due in part to the fact that many money managers don't have the returns to keep people coming back. It's also due in part to people's mistrust of the market (and financial industry in general). They are simply allocating their money in accordance with their risk appetite.
Doesn't it seem self-limiting? At some point, if prices become totally irrational, wouldn't active investors profit by taking advantage of predictable index fund transactions?
This is an under-appreciated point... if 99 people leave money on the table, and the 100th person picks it up, we're back to efficiency in the aggregate.
There will always be active investors. People will always think they know a way to succeed in the market that nobody else does. It's human nature. Plus, there will always be VCs, hedge funds, and other high-risk, high-reward investment vehicles used by the wealthy to add some spice to their otherwise conservative portfolios.
There may be fewer active investors than before, but that doesn't mean the market won't function.
>warned that index funds might grow to the point at which new investments could be massively mispriced.
This situation will be easy to spot from indicators like P/E ratio. P/E limited index funds will be new hotness and active investors should get better returns.
There is bigger problem than index funds and it's closet indexing. Many portfolio managers that claim to be active investors secretly follow their benchmark index without exactly replicating it. This is fraudulent behavior.
> There is bigger problem than index funds and it's closet indexing. Many portfolio managers that claim to be active investors secretly follow their benchmark index without exactly replicating it. This is fraudulent behavior.
As long as they can also provide competitive maintenance fees and tracking errors don't play against them, I don't see much of a problem. If they consitently do worse than the ETFs based on the same indexes with a similar risk profile, the market will eventually punish them for under-delivering.
If they only make a few picks that end up doing well, keeping the rest of the benchmark for a balanced risk profile seems sensible to me.
> If businesses are to be able to raise capital by selling shares to outsiders, “you need a deep market of active investors willing to take a view on the valuation of the company,” Inigo Fraser-Jenkins, head of quantitative strategy at Bernstein in London and lead author of the “Worse than Marxism” report, told me this week.
And that's a terrible investment strategy to ask of the average layman, the people who are concentrating on index investing.
> Because corporations know that, says Prof. Heemskerk, coziness and complacency may arise. “If you have only long-term investors, how do you keep management on their toes?”
We've a ways to go before the pendulum has swung enough in that direction. I'm more concerned about the tendency to seek short-term profits at the expensive of long-term investment in today's Wall Street CEOs.
> But, he adds, that would require indexing to grow immensely from today’s levels. Probably not until passive funds are at least 90% of the market could such chaos arise, he argues.
That's a pretty hypothetical scenario, isn't it? Index funds, ETFs in particular, are a brilliant idea that allows ordinary people to participate in the success of market trailblazers.
If it wasn't for index funds most people wouldn't be able to make reasonable investment decisions because they're not investment bankers who deal with that sort of business on a daily basis. Even investment bankers fail with their investments most of the time. It's usually just the few successful investments or things like arbitrage that balance out the odds.
Ordinary people usually neither have the knowledge nor the resources to do investments this way, so index funds probably are the best option for accumulating wealth over a period of time.
> A report this past week from investment firm Sanford C. Bernstein, titled “The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism,” warned that index funds might grow to the point at which new investments could be massively mispriced.
In which case the actively managed funds which identify the mispriced assets would start making money and attract investors again. You know there's trouble brewing in the industry when mutual funds are trying to sell investors on "it's good for the economy!"
> That’s largely because index funds trade so much less often than active managers. On a typical day, only 5% to 10% of total trading volume comes from index funds, says a Vanguard spokesman.
I'm surprised the author omitted it, but can anyone comment whether this is different for robo investors (Wealthfront, Betterment) vs a traditional index fund like Vanguard?
They give you the canned advice that your local Financial advisor gives you, minus the quarterly meeting and phone therapy when the market goes down, and plus some automated intelligent handling of capital gains to reduce your tax exposure.
Can high-frequency traders replace active investors in an ideal world. Ideally, the price should be the best estimate of the value of the company based on all publicly available information. When new information is released, high frequency traders should rush to profit from the discrepancy. Further, they can market make based off their knowledge of the stock's true value. However, this business should face increasing competition until it becomes a low-margin business. I don't see any inherent reason, active investing should be super profitable. In the end, it is just another business like any other.
Besides the issue of corporate ownership / concentration, index funds are also increasing the risk of a market crash. One of the selling points for index funds is that they supposedly offer great diversification and this might be true in normal times but in a financial panic people will pull out of index funds and drive correlations to 1. E.g. if there's a crash in health care, panicked investors won't just be pulling out of health care they'll be pulling out of the market as a whole.
I'm not sure that a market crash is a prima facie bad thing. Market crashes often precede or accompany economic recessions but I'm inclined to believe that they are a symptom or result rather than a cause. An economic recession is a bad thing due to increased unemployment, among other reasons.
If there is a real contraction in the health care sector and people react by pulling out of the market entirely then that is a good thing for people looking to put money into the market; the rest of the market is on sale (relative to its "real" value). Even if the market is made up entirely of indices, the market as a whole will end up appropriately priced. Those who panic sell will lose money but the index will bounce back assuming non-health care assets truly were undervalued.
Yes, but this does not diminish the value of the companies in the long term. Remember that index funds are an investment vehicle for decades, not months.
[+] [-] Analemma_|9 years ago|reply
[+] [-] henrikschroder|9 years ago|reply
It would be funny if it wasn't so incredibly blatant.
[+] [-] gozur88|9 years ago|reply
>Because corporations know that, says Prof. Heemskerk, coziness and complacency may arise. “If you have only long-term investors, how do you keep management on their toes?” he asks. “Where are the checks and balances when you have such large block holdings?”
The whole system depends on the fact that investors have an interest in voting for a competent board and are willing to sell their shares if the company doesn't seem to be managed well. If the actual owners of the company aren't paying attention the opportunities for self-dealing and just plain incompetence on the part of company officers multiply.
[+] [-] blazespin|9 years ago|reply
[+] [-] mc32|9 years ago|reply
[+] [-] wldcordeiro|9 years ago|reply
[+] [-] ttcbj|9 years ago|reply
http://www.mymoneyblog.com/how-to-minimize-investment-return...
It is essentially a thought experiment about what would happen if everyone switched to one big index fund.
But, it glosses over the issue of individual security pricing and corporate management, which would become issues in a 100% pure index environment.
Of course, we won't ever get a 100% pure index environment, because the closer you approach it, the more incentive there is for active managers to exist.
I think what is really happening is that as more people use indexing, the less talented active managers are driven out of business. A small number of very talented active managers may eventually find themselves in a highly competitive market to exploit pricing inefficiencies, and they will end up incidentally providing management oversight and marginal pricing services to the indexers. These active managers will probably look more and more like private equity firms (taking an active hand in management), and less and less like traditional arms-length traders.
As long as this small number of talented firms isn't allowed to collude with each other, or self-deal unethically by controlling management, everything should be fine. In fact, having met some less talented active traders in person, I suspect that the quality of marginal pricing and managerial oversight may go _up_ as the number of active managers decreases, and the less informed and talented among them are eliminated.
[+] [-] smallnamespace|9 years ago|reply
... and I've got a bridge to sell you.
More seriously though, the smaller the number of players, the more likely (and easy) collusion becomes. Successful cartels always have relatively few players.
[+] [-] hkmurakami|9 years ago|reply
[+] [-] cesarbs|9 years ago|reply
But that's not what a lot of index investors do. Indexers enjoy adding tilts to their portfolios. So some people will buy value funds, others will buy small cap funds, and yet others will buy small value funds. There are people who overweight certain sectors, like REITs or utilities. There are those who invest in international index funds (with all their variations) and those who don't. So there's a huge number of combinations you can think of when it comes to indexing.
Now, with people indexing like that, there would still be market liquidity. Maybe not as much as when there are single stocks being actively traded, but on any given day there will be people buying into different indexes, selling shares, or rebalancing.
Valuation would become troublesome though, but at least people would still get some return from dividends.
[+] [-] tedmiston|9 years ago|reply
Plus everyone knows the S&P is a terrible benchmark because it excludes mid- and small-cap cos.
After watching mine from a far for ~7 years, I've come to accept that one really needs to invest in multiple index funds to get global diversification as well.
[+] [-] StavrosK|9 years ago|reply
[+] [-] pcsanwald|9 years ago|reply
[+] [-] ph0rque|9 years ago|reply
[+] [-] Animats|9 years ago|reply
So index funds are not eating the world.
Most Wall Street traders underperform the market. Even the hedge fund crowd mostly underperforms the market. "A Random Walk Down Wall Street" is real.
[+] [-] czinck|9 years ago|reply
Vanguard owning 6% of the entire US stock market value is huge. You could reasonably re-title this "Is Vanguard Eating the World" and be right if it wasn't for Blackrock and other ETF firms being close behind them.
Sources: https://finance.yahoo.com/quote/AAPL/holders?p=AAPL and similar pages.
[+] [-] gnaritas|9 years ago|reply
It's a real book, but it doesn't prove the market is random, nothing does as the efficient market hypothesis is just that, an unproven hypothesis lacking even enough evidence to become a working theory.
That certain funds consistently beat the market year in and year out for decades is enough to disprove the notion that markets are random; they're not.
[+] [-] tptacek|9 years ago|reply
[+] [-] AstroJetson|9 years ago|reply
Lots of money and market push there as indexes.
Bogle said that there could be issues at the 90% level, so we are still pretty far away.
My issue is funds that are Index 500 or DJI average are set by someone else. Hence the huge number of funds that own Apple and can push on them. When they rebalances those indexes, it can be a traumatic event.
On the other hand, index funds are a way of playing par golf with your money every day.
[+] [-] Retric|9 years ago|reply
So, the real question is what percentage of funds are index funds.
[+] [-] unknown|9 years ago|reply
[deleted]
[+] [-] kldaace|9 years ago|reply
The situation described is clearly not a Nash equilibrium. If you have special, accurate information on the price of a security, then you're going to act on it. Why would no one be doing the work of pricing something if it's profitable? Sounds like actively managed mutual funds are getting antsy because people are starting to realize that they're getting screwed not going with index funds.
[+] [-] logfromblammo|9 years ago|reply
All companies converge on the same P/E ratio, and the ratio of the index depends on how much investor money is chasing the overall productive activity of every [investable] company in the economy.
It wouldn't be the end of the world, by far.
But it is doubtful this will ever get even close to happening, because some investors will always be gamblers at heart, and if they learn that Coca-Cola is releasing a new beverage flavor, they will use the financial markets to make bets on whether it will be insanely popular or a colossal failure.
[+] [-] turc1656|9 years ago|reply
That being said, I fully believe there will always be active investors. As others have mentioned, if there is an opportunity to make money in the market due to something like passive index funds being slower on the uptake, it will be made.
If I had to interpret the core argument being made here, it is basically that there is a fear of a positive feedback type scenario where money keeps getting dumped into companies simply because it always has. But it can be highly profitable to beat out the slow, passive money by doing your due diligence. For this reason, active management will always exist.
Also, I am fortunate enough to work on some of the more complex and interesting products in the industry (at least I believe so, haha). I can tell you that there are definitely sanity checks put in place for this kind of scenario. Most of it revolves around fundamental ratios built into these product methodologies (i.e. P/E ratio must be within a rational range, company must produce stable income for the past 5 years, etc.). More importantly, securities in these portfolios are frequently weighted (at least in part) upon those fundamental ratios. So if a company starts to deteriorate, the size of the position in the fund will be decreased. Much of what the article talks about seems to be negated by this and becomes a non-issue. I think those arguments would apply more to benchmark products which don't have those kinds of requirements. Then again, many benchmarks are used for exactly that - benchmarking - and aren't directly invested in. There are, of course, indices like the S&P 500 that have significant sums of money attached to them, but they are the exception, not the rule. Most index products deemed "investment-grade" are STRATEGY based, not benchmark based.
Basically, there is room in the market for both. I think we are simply seeing the progression towards a new equilibrium, nothing more. That equilibrium is where the new balance of those willing to take a higher risk meet those that want the less risky, low cost products that we provide. There is simply a much smaller portion of the population willing to pay higher fees and have a larger risk (but with possibly greater reward). And that is due in part to the fact that many money managers don't have the returns to keep people coming back. It's also due in part to people's mistrust of the market (and financial industry in general). They are simply allocating their money in accordance with their risk appetite.
[+] [-] hulahoof|9 years ago|reply
[+] [-] empath75|9 years ago|reply
[+] [-] bbayles|9 years ago|reply
[+] [-] Terr_|9 years ago|reply
[+] [-] twblalock|9 years ago|reply
There may be fewer active investors than before, but that doesn't mean the market won't function.
[+] [-] nabla9|9 years ago|reply
This situation will be easy to spot from indicators like P/E ratio. P/E limited index funds will be new hotness and active investors should get better returns.
There is bigger problem than index funds and it's closet indexing. Many portfolio managers that claim to be active investors secretly follow their benchmark index without exactly replicating it. This is fraudulent behavior.
[+] [-] jpetso|9 years ago|reply
As long as they can also provide competitive maintenance fees and tracking errors don't play against them, I don't see much of a problem. If they consitently do worse than the ETFs based on the same indexes with a similar risk profile, the market will eventually punish them for under-delivering.
If they only make a few picks that end up doing well, keeping the rest of the benchmark for a balanced risk profile seems sensible to me.
Please explain where the problem lies exactly?
[+] [-] ergest|9 years ago|reply
[+] [-] tedmiston|9 years ago|reply
And that's a terrible investment strategy to ask of the average layman, the people who are concentrating on index investing.
[+] [-] ceejayoz|9 years ago|reply
We've a ways to go before the pendulum has swung enough in that direction. I'm more concerned about the tendency to seek short-term profits at the expensive of long-term investment in today's Wall Street CEOs.
[+] [-] BjoernKW|9 years ago|reply
That's a pretty hypothetical scenario, isn't it? Index funds, ETFs in particular, are a brilliant idea that allows ordinary people to participate in the success of market trailblazers.
If it wasn't for index funds most people wouldn't be able to make reasonable investment decisions because they're not investment bankers who deal with that sort of business on a daily basis. Even investment bankers fail with their investments most of the time. It's usually just the few successful investments or things like arbitrage that balance out the odds.
Ordinary people usually neither have the knowledge nor the resources to do investments this way, so index funds probably are the best option for accumulating wealth over a period of time.
[+] [-] ramblenode|9 years ago|reply
In which case the actively managed funds which identify the mispriced assets would start making money and attract investors again. You know there's trouble brewing in the industry when mutual funds are trying to sell investors on "it's good for the economy!"
[+] [-] unknown|9 years ago|reply
[deleted]
[+] [-] tedmiston|9 years ago|reply
I'm surprised the author omitted it, but can anyone comment whether this is different for robo investors (Wealthfront, Betterment) vs a traditional index fund like Vanguard?
[+] [-] Spooky23|9 years ago|reply
They give you the canned advice that your local Financial advisor gives you, minus the quarterly meeting and phone therapy when the market goes down, and plus some automated intelligent handling of capital gains to reduce your tax exposure.
[+] [-] atestu|9 years ago|reply
[+] [-] davidgerard|9 years ago|reply
good Lord
[+] [-] gersh|9 years ago|reply
[+] [-] lazyevaluate|9 years ago|reply
[+] [-] uiri|9 years ago|reply
If there is a real contraction in the health care sector and people react by pulling out of the market entirely then that is a good thing for people looking to put money into the market; the rest of the market is on sale (relative to its "real" value). Even if the market is made up entirely of indices, the market as a whole will end up appropriately priced. Those who panic sell will lose money but the index will bounce back assuming non-health care assets truly were undervalued.
[+] [-] ceejayoz|9 years ago|reply
[+] [-] toennisforst|9 years ago|reply
[+] [-] csandstedt|9 years ago|reply