This article brings up a point I used to worry about - if people are just automatically pumping money into a list of stocks, how does the price remain connected to reality?. But apparently the answer is that mis-priced stocks present an arbitrage opportunity (https://www.investopedia.com/terms/i/indexarbitrage.asp), so as long as a few people are paying attention, the price remains rational, and the remaining people paying attention are rewarded for doing so. The Economist had an article about this issue recently and they concluded that the main effect of Index Funds was to drive low-performance fund managers out of business.
Index arbitrage is a mechanism that corrects mispricings between an index and its constituents. That isn't the mispricing being discussed. What is being discussed here is the potential for the prices of individual stocks to deviate from any reasonable level because of their inclusion in an index.
To some extent, it's just a matter of supply and demand. Because so many people are investing passively, inclusion in an index with highly traded ETFs can cause huge demand for a stock that no one would have particularly cared about otherwise. There are tons of examples of this around the Russell indices, but stocks in most popular indices carry higher multiples than similar companies outside of them. There is also what George Soros called reflexivity - this increase in stock price makes it more likely that your business will survive because it makes financing the business easier. A large market cap both means you can issue shares cheaply, and it makes banks more likely to lend to you. That helps the business stay alive, but it doesn't necessarily improve their underlying business. Without anyone fundamentally evaluating these companies, such situations can persist indefinitely. Short selling is also made hard by the heavy demand created by additional inflows to these indices. Even if you identify a mispriced company, its continued inclusion in the index might prevent the price action that would remedy the situation.
In the end, I don't think this is the end of the world, but there is the old saying that bad money drives out good. This kind of mania makes it hard for normal feedback mechanisms to function appropriately. The most direct costs will be born by those who invest in such instruments, but it also adds greatly to the correlation of the markets, since price movements are now implicitly tied to inflows of money from markets.
> The Economist had an article about this issue recently and they concluded that the main effect of Index Funds was to drive low-performance fund managers out of business.
If that's the case it should drive most fund managers out of business since most of them don't beat the S&P over time.
And as more money gets funneled to index funds, the vanguards and fidelitys of the world could lower fees on their index funds which should put even more pressure on most fund managers which could create a vicious cycle. Maybe we'll be left with just index funds and a handful of rock star fund managers.
Yeah, even more intuitively, there will just be a Nash equilibrium:
1. Everyone wants to make money.
2. People will look for the best way to make money.
3. If enough people are in index funds, the best way is to go active. If enough people are active, it is best to do index funds. Therefore we’ll have an equilibrium where it doesn’t matter too much which you choose (as long as you’re reasonably smart not to get ripped off).
This is not entirely true. Passive funds only perform transactions in response to change in market cap. Market cap value change for any company is entirely controlled by active funds. In other words, you can think of passive funds as observers in market who follows what active funds will do in aggregate. The entire reason passive funds out perform active funds is because they sort of act like ensemble of active funds.
Now think of a world where passive funds dominates investments and very few active funds survive. Now the market cap variance increases and small changes induced by active funds gets hugely amplified by passive funds. For example, a hedge fund may decide to liquidate their position on XYZ due to random reason and can trigger 1% change in price (because active funds willing to buy might not be high in number). This then immediately changes market cap and all passive funds will rush to liquidate as well which will tank that company. This obviously can be gamed by clever active funds.
As more and more investment becomes passive, I think the ROI for those investors reduces significantly compared to active investors. I am working on theory part for this. If anyone is interested, please feel free to email me.
All you need to do is buy cheap leap puts on whichever stocks you feel have a PE ratio that is unsustainable, and wait.
I don't know if Sears received a lot of index funding but I'm sure TGT did. It's day of judgment came last summer. AAPL is next. It will take years, but you can only screw customers secretly for so long.
Theoretically, I think the concern is reasonable. The "concern" here being if everyone switches to passive funds, then the behavior of markets will change. However, when you look at the numbers, it doesn't seem like this concern is actually a reality.
> The market capitalization of the S&P 500 is roughly $22 trillion as I write this. The entire ETF market in the U.S. is $3 trillion. That’s 14%. Even the whole industry—about $4 trillion, would only be 18%.
This statistic was actually a big wake up call for me about 6 months ago. For a long time I had been investing based on theoretical ideas, like the one mentioned in this Bloomberg article that we're discussing. After I saw this statistic, I realized that I needed to look closer at the numerical reality when making investing decisions. This is probably obvious to many of you. I'm just sharing the moment when this insight really hit home for me.
There's a phrase we use in investment banking: "talking his own book." A trader is talking their own book when the superficially neutral view they give of the market is designed to promote the value of their own positions. The active managers that Levine quotes are talking their own books when they decry passive funds. As ever, one should follow the money, and ask who stands to benefit if a view of recommendation is implemented. "Where are the customers yachts?"
A pet theory of mine: if everybody starts investing in passive funds replicating indexes, then the creativity will go into increasingly more sophisticated indexes.
You might for instance want to make the bet that the market at large is systematically underestimating the risks related to global warming in particular, and the environment in general. Said differently, it is entirely possible that governments will start to tax the hell out of various externalities, like CO2 emissions, or plastic garbage generation. Or maybe courts will ask companies to pay to clean up after their own mess.
If you believe that this is true, then indexes (existing or being created) weighting in those risks will over-perform the S&P 500 in the medium term, until a couple of companies are wiped out and analysts start to correctly price in these risks...
That's just one example of the kind of creative index that could be created.
> The function of the capital markets is to allocate capital.
I never fully grasped this idea. I have no problem understanding that venture capitalists, angel investors or investors that buy shares at IPO do allocate capital. However, why is trading existing shares considered "allocating capital"?
It's a price mechanism. The logic is that by having a liquid secondary market where investors are free to trade securities whenever they want, you always have an up-to-date price that reflects all information known about future prospects for that business. (If you didn't, then someone with superior information could trade based on that and reap a profit, which increases the amount of capital they have to trade on in the future, which means that eventually all the capital ends up in the hands of the firms with the best information.)
Then whenever a company needs capital for future expansion - whether it be for secondary stock offerings, new factories, or stock options to entice key researchers or executives - they have an accurate price on the stock with which to judge the cost of capital. If their stock price is low and capital expense is high, they may decide that the capital investment won't increase the value of the company enough to be worth it; the market has prevented capital from flowing to inefficient businesses. (Again, if they guess irrationally, they go out of business, and the system remains rational even if management isn't.) Similarly, if the market puts a high price on the stock because there's a belief that what they're doing is important and will reap big rewards in the future (eg. Tesla), they'll find it cheaper to make big capital investments.
The early-stage startup financing market - angels and VCs - is actually both quite illiquid and quite inefficient - prices at that stage are basically just guesses, which is why some companies rapidly increase in value and many others go to zero. It too depends upon the liquid secondary market after IPO to keep actors rational, though - if VCs could not sell their shares later on the public markets, they would have no incentive to invest in startups.
This is one thing that frustrates me about investing in the stock market. The idea of calling trading "investing" feels so inaccurate. I didn't invest in your fortune 500 company, I bet on the idea that other people down the line would bet on the same company but that they'd bet even harder. I wish investing was more like selling small corporate loans. I'll give Amazon $50 today if they pay me $100 in 10 years. Sounds great to me, take my money, do something with it, and pay me back. That's investing.
I've grown much more comfortable investing in real estate as a result of this. When I invest in something I want to see how that investment was used, how it helped, and get returns based on how successful my ideas were. If I renovate a house or invest in my buddy's business, I get exactly that. It may fail, but at least my money mattered and I saw what it did to help. When I invest in the stock market I get none of this.
Every purchase of a share rewards the previous owner with some cash. Follow that chain of trades backward and eventually you end up rewarding the founder, the early employees, the VCs, etc. It's a long, tenuous chain, but it's there.
I agree with the general point that most trades of mature companies don't seem to have a material effect on the expectations of today's founders, early employees, VCs, etc. Though in theory if liquidity dried up enough or valuations fell, those signals would noisily backpropagate through prices and shift expectations of rewards.
> However, why is trading existing shares considered "allocating capital"?
Because the company is made of capital. It has a plot of land with a factory, equipment for making brake pads, raw materials, a trade name that engenders goodwill with customers etc. When you buy a share, that share of ownership of the capital is allocated to you. You get a vote in how it's used. You could vote to keep making brake pads as ever, or mortgage the factory to expand into brake rotors, or cease operations and sell the individual assets to the highest bidder.
In principle you could be the deciding vote and someone else could have made a different decision than you.
One possible way is if we consider capital allocation in terms of acquisitions, where one company acquires other companies by giving them stock instead of cash (which is what a lot of pre dot-com era telecom companies did to acquire customers + coverage like Verizon or the notorious Worldcom) and the ease of those acquisitions was largely based on the demand of that stock and thus the stock price.
If I buy shares in a company say RDSB (Shell) I am allocating my capital to that company and someone else is selling theirs as they don't want to own that asset any more.
I did this when the share price was low so I was taking a long term view that it would recover and I would capture that value and also have the dividend at an expressed yield on between 6-7%.
A functional capital market provides liquidity and higher valuation to an investment. Without these two you would have less capital going into companies. Trading shares may have little immediate effect, but certainly do for the next share offering.
The article is interesting. We replaced the baity title with representative language from the text. Hopefully that will spare us all yet another boring flamewar about the c-word.
If anyone can suggest a more accurate and neutral title, we can change it again.
Edit: ok, you guys didn't like "When analysts are replaced with index funds, the market stops allocating capital", so I dug up another representative sentence from the article.
The best way to complain about a title is to offer a better one, so if you don't like this one either, maybe take a crack at it?
The "index funds" thing is throwing people off the track of the article, which is more about robots than index funds proper. Perhaps "when human analysts are replaced with algorithmic robots, capital markets will feature less activity but what about efficiency?".
I have thought for a while that most of the financial advisers are just middlemen on the stock market, getting a small amount of my money by trading for me. If I just buy index funds I'll do fine. My financial adviser who charges me at 0.75% management fee didn't protect me from huge losses in 2008 and 2009. I don't necessarily blame her, but she was not really different than buying an index fund or a managed year retirement fund.
If you went to a financial advisor 30 years ago, they would have said "give me your money and I'll make you a portfolio". He/she would then have bought most of the S&P 500 or some other exchange in a diversified manner buying equities and bonds. They would have shifted around your allocations ever so slightly every quarter, buying some stocks and selling others. But really, the strategy was to buy and hold. Bonds were similar.
You're getting downvoted, but this is exactly what happens with most active managers these days. Seriously, go to a local branch of a big bank, start a managed investment account, they'll give you a 1-1.5% fee portfolio and tell you about how well diversified and well organized it is for your risk level. And it is both those things! But dig into the investments and you'll see... Vanguard, Vanguard, iShares, Vanguard, Vanguard, iShares, Blackrock, Blackrock, iShares, etc.
Sure there are traders on wall street looking to beat the index funds with manual trading, and these guys will always exist. But most active managers these days are just buying index funds and slapping on an useless fee. This is why when I pulled my money out of my bank's managed investment account and into a Vanguard account, I didn't suddenly change a portion of the market from active to passive investing, I just removed an unnecessary 1.25% fee that got me nothing and did nothing positive for the economy.
The issue is that in the long run, index funds or passive investors do outperform hedge funds or active investment management as shown by Warren Buffett:
There are a lot of factors at play but simply for your non-analyst mom-and-pop investors, they don't have time and the know-how to investigate stocks and index funds are just much more accessible and as they say, in the long run we are all dead.
To me, the interesting question is: if the market is mostly index funds, what does that do?
Lots of passive money means that the market is an amplifier for the decisions of those who choose to make their own decisions. Want $AMZN to have a little more market capitalization? Buy some, and the entire market is forced to follow you. Sell some, and they will follow you, too.
It is herd behavior (which can be quite beneficial), but it affords certain advantages to those wily enough to use the herd instinct for their own designs.
Not quite. One reason why many passive indices are market-cap weighted is so they do not have to regularly trade. Suppose a fund needs to be 1% AMZN. Now you fire up a hype train and the price of AMZN doubles. It now represents twice as much of the index, market-cap weighted, so the fund wants to be 2% into AMZN, but their stake has doubled with the price so there’s no trading needed!
That said, you can generally pick up an extra point or two of returns by equally weighting and trading against the daily volatility, and some funds do this, but they cannot scale up to have as large capacity.
The "you" refers to the "index fund manager", yes?
If so, then your thesis doesn't make sense. The index fund manager's job is to maintain the fund's allocation according to the index calculation to the best of his ability, not "go out and buy some $AMZN cos it looks cheap" (which opens up the fund for civil lawsuits for not adhering to the prospectus), or to "manipulate the herd".
Tracking errors happen, but those are incidental to the need for re-balancing and are not outright actions undertaken by the fund manager for the purposes stated above.
The biggest danger of all this money in index funds is that the market becomes to big to fail and the government has to keep propping it up. In fact, it becomes a way to actually disburse wealth - enact policies such that they go to people in the market.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
Oh yeah? which benefits? When you know that on average, an astonishing 90 percent of actively managed mutual funds underperformed their benchmark indexes over the preceding 15 years. The index superiority was consistent and overwhelming.
I recently read the Little Book Of Common Sense Investing, and it was brilliant.
This is a common refrain. Passive indexing is killing the market. ETFs are killing the market.
I take a very cyclical approach on everything. The rise of passive actually creates huge opportunities for active managers. We see this already in the ETF landscape: you can invest in any product today for very cheap. This creates a new challenge to manage the portfolio of the future. 60/40 allocations are the exposures of yesterday.
It's actually a great article with a HN title that misrepresents what it is actually about. Anyway, with that proviso, here is my take:
So long as the bots aren't conscious there will be no bot-dominated stock market. Too much information is wrapped up in conscious thought that isn't easily expressed in stock market pattern matching. The article mentions that the line between active and passive isn't as clear as people that make it out to be say it is, and that is true, but it's also incomplete. Certain events are conceivable to humans that are not conceivable to machines. Short of simulating humans, anyway.
For example, I as a human know that there is a non-zero chance that the DPRK and USA get into a nuclear war. I can know that Trump defaulting on Chinese held US debt is something that is at least on the table. The quants can try to pull in percentages from experts all they want (and they were calling my nuclear weapons arms control friends a year ago asking for percentiles) but it isn't the same thing because the model is still fundamentally concerned with statistics and many of the events we understand as humans have implicit dependence to each other that is hard to model.
It's far easier to employ a small number of smart people and have the models serve and be tuned by them than to have the models actually run everything. Plus you don't even really need them sometimes. Take Bitcoin, for example. The gains were obvious. The incentives were completely aligned and the friction was in the buy side and it was temporary. I didn't need to model out Bitcoin to buy it at $4 CAD. I just had to think about it from first principles, something that is currently not possible with ML.
This is fearmongering. If the market approached an allocation to index funds that enabled arbitrage, more actors would switch to arbitrage eliminating such arbitrage.
It is a self-balancing situation. A scenario of "oh my god, everyone is just putting their money on index funds" would never happen.
Another way to think about it is in terms of evolutionary stable strategy. Index funds and arbitrage-seeking reach a Nash equilibrium at some point (far more index-allocated than today's market) where arbitrage-seekers will reap returns almost equal to index funds, as index allocation starts o not capture all available market information.
If the market deviates from that point, forces push it back into that point. If the market starts over-allocating into arbitrage-seeking (like today), returns on index funds will beat arbitrage, pushing capital back into index funds. If the market over-allocates in index funds, index funds will return below arbitrage, pushing money out of index funds.
Edit: Right now, the market is still far over-allocated into the arbitrage-seeking side, resulting in a natural shift to index funds.
The worst part is that many governments around the world use peoples' Superannuation/401k accounts to invest in index funds. In Australia, employee contributions of 12% are mandatory... So basically the government is driving inequality and centralization of wealth using people's own money.
Back when hedgies were the masters of the universe and every punk and his dog was starting a hedge fund and when you could beat treasury bills with "market neutral" strategies people used to blame correlation on hedgies.
I'm not sure what the concern is with index funds. For now they're a better deal than active funds but if they take over too much of the market that will leave more opportunities for active investors to succeed.
[+] [-] PopePompus|7 years ago|reply
[+] [-] conjecTech|7 years ago|reply
To some extent, it's just a matter of supply and demand. Because so many people are investing passively, inclusion in an index with highly traded ETFs can cause huge demand for a stock that no one would have particularly cared about otherwise. There are tons of examples of this around the Russell indices, but stocks in most popular indices carry higher multiples than similar companies outside of them. There is also what George Soros called reflexivity - this increase in stock price makes it more likely that your business will survive because it makes financing the business easier. A large market cap both means you can issue shares cheaply, and it makes banks more likely to lend to you. That helps the business stay alive, but it doesn't necessarily improve their underlying business. Without anyone fundamentally evaluating these companies, such situations can persist indefinitely. Short selling is also made hard by the heavy demand created by additional inflows to these indices. Even if you identify a mispriced company, its continued inclusion in the index might prevent the price action that would remedy the situation.
In the end, I don't think this is the end of the world, but there is the old saying that bad money drives out good. This kind of mania makes it hard for normal feedback mechanisms to function appropriately. The most direct costs will be born by those who invest in such instruments, but it also adds greatly to the correlation of the markets, since price movements are now implicitly tied to inflows of money from markets.
[+] [-] qubax|7 years ago|reply
If that's the case it should drive most fund managers out of business since most of them don't beat the S&P over time.
https://www.cnbc.com/2017/02/27/active-fund-managers-rarely-...
And as more money gets funneled to index funds, the vanguards and fidelitys of the world could lower fees on their index funds which should put even more pressure on most fund managers which could create a vicious cycle. Maybe we'll be left with just index funds and a handful of rock star fund managers.
[+] [-] Moodles|7 years ago|reply
1. Everyone wants to make money.
2. People will look for the best way to make money.
3. If enough people are in index funds, the best way is to go active. If enough people are active, it is best to do index funds. Therefore we’ll have an equilibrium where it doesn’t matter too much which you choose (as long as you’re reasonably smart not to get ripped off).
[+] [-] prostoalex|7 years ago|reply
[+] [-] erik_seaberg|7 years ago|reply
[+] [-] dustingetz|7 years ago|reply
[+] [-] sytelus|7 years ago|reply
Now think of a world where passive funds dominates investments and very few active funds survive. Now the market cap variance increases and small changes induced by active funds gets hugely amplified by passive funds. For example, a hedge fund may decide to liquidate their position on XYZ due to random reason and can trigger 1% change in price (because active funds willing to buy might not be high in number). This then immediately changes market cap and all passive funds will rush to liquidate as well which will tank that company. This obviously can be gamed by clever active funds.
As more and more investment becomes passive, I think the ROI for those investors reduces significantly compared to active investors. I am working on theory part for this. If anyone is interested, please feel free to email me.
[+] [-] anoncoward111|7 years ago|reply
I don't know if Sears received a lot of index funding but I'm sure TGT did. It's day of judgment came last summer. AAPL is next. It will take years, but you can only screw customers secretly for so long.
[+] [-] unknown|7 years ago|reply
[deleted]
[+] [-] retube|7 years ago|reply
[+] [-] kaycebasques|7 years ago|reply
> The market capitalization of the S&P 500 is roughly $22 trillion as I write this. The entire ETF market in the U.S. is $3 trillion. That’s 14%. Even the whole industry—about $4 trillion, would only be 18%.
https://www.etf.com/sections/blog/no-etfs-dont-own-37-sp-500
This statistic was actually a big wake up call for me about 6 months ago. For a long time I had been investing based on theoretical ideas, like the one mentioned in this Bloomberg article that we're discussing. After I saw this statistic, I realized that I needed to look closer at the numerical reality when making investing decisions. This is probably obvious to many of you. I'm just sharing the moment when this insight really hit home for me.
[+] [-] osullivj|7 years ago|reply
[+] [-] Xixi|7 years ago|reply
You might for instance want to make the bet that the market at large is systematically underestimating the risks related to global warming in particular, and the environment in general. Said differently, it is entirely possible that governments will start to tax the hell out of various externalities, like CO2 emissions, or plastic garbage generation. Or maybe courts will ask companies to pay to clean up after their own mess.
If you believe that this is true, then indexes (existing or being created) weighting in those risks will over-perform the S&P 500 in the medium term, until a couple of companies are wiped out and analysts start to correctly price in these risks...
That's just one example of the kind of creative index that could be created.
[+] [-] ndesaulniers|7 years ago|reply
[+] [-] tryptophan|7 years ago|reply
[+] [-] wcoenen|7 years ago|reply
https://www.ishares.com/us/products/271054/ishares-msci-acwi...
[+] [-] sysk|7 years ago|reply
I never fully grasped this idea. I have no problem understanding that venture capitalists, angel investors or investors that buy shares at IPO do allocate capital. However, why is trading existing shares considered "allocating capital"?
[+] [-] nostrademons|7 years ago|reply
Then whenever a company needs capital for future expansion - whether it be for secondary stock offerings, new factories, or stock options to entice key researchers or executives - they have an accurate price on the stock with which to judge the cost of capital. If their stock price is low and capital expense is high, they may decide that the capital investment won't increase the value of the company enough to be worth it; the market has prevented capital from flowing to inefficient businesses. (Again, if they guess irrationally, they go out of business, and the system remains rational even if management isn't.) Similarly, if the market puts a high price on the stock because there's a belief that what they're doing is important and will reap big rewards in the future (eg. Tesla), they'll find it cheaper to make big capital investments.
The early-stage startup financing market - angels and VCs - is actually both quite illiquid and quite inefficient - prices at that stage are basically just guesses, which is why some companies rapidly increase in value and many others go to zero. It too depends upon the liquid secondary market after IPO to keep actors rational, though - if VCs could not sell their shares later on the public markets, they would have no incentive to invest in startups.
[+] [-] _uhtu|7 years ago|reply
I've grown much more comfortable investing in real estate as a result of this. When I invest in something I want to see how that investment was used, how it helped, and get returns based on how successful my ideas were. If I renovate a house or invest in my buddy's business, I get exactly that. It may fail, but at least my money mattered and I saw what it did to help. When I invest in the stock market I get none of this.
[+] [-] tedsanders|7 years ago|reply
I agree with the general point that most trades of mature companies don't seem to have a material effect on the expectations of today's founders, early employees, VCs, etc. Though in theory if liquidity dried up enough or valuations fell, those signals would noisily backpropagate through prices and shift expectations of rewards.
[+] [-] AnthonyMouse|7 years ago|reply
Because the company is made of capital. It has a plot of land with a factory, equipment for making brake pads, raw materials, a trade name that engenders goodwill with customers etc. When you buy a share, that share of ownership of the capital is allocated to you. You get a vote in how it's used. You could vote to keep making brake pads as ever, or mortgage the factory to expand into brake rotors, or cease operations and sell the individual assets to the highest bidder.
In principle you could be the deciding vote and someone else could have made a different decision than you.
[+] [-] forkLding|7 years ago|reply
[+] [-] C1sc0cat|7 years ago|reply
I did this when the share price was low so I was taking a long term view that it would recover and I would capture that value and also have the dividend at an expressed yield on between 6-7%.
[+] [-] nicholas73|7 years ago|reply
[+] [-] unknown|7 years ago|reply
[deleted]
[+] [-] dang|7 years ago|reply
If anyone can suggest a more accurate and neutral title, we can change it again.
Edit: ok, you guys didn't like "When analysts are replaced with index funds, the market stops allocating capital", so I dug up another representative sentence from the article.
The best way to complain about a title is to offer a better one, so if you don't like this one either, maybe take a crack at it?
[+] [-] tanderson92|7 years ago|reply
[+] [-] unknown|7 years ago|reply
[deleted]
[+] [-] loeg|7 years ago|reply
[+] [-] Terr_|7 years ago|reply
Relevant past topic: https://news.ycombinator.com/item?id=12368136
[+] [-] Latteland|7 years ago|reply
[+] [-] jypepin|7 years ago|reply
[+] [-] jorblumesea|7 years ago|reply
Is that not indexing under another name?
[+] [-] _uhtu|7 years ago|reply
Sure there are traders on wall street looking to beat the index funds with manual trading, and these guys will always exist. But most active managers these days are just buying index funds and slapping on an useless fee. This is why when I pulled my money out of my bank's managed investment account and into a Vanguard account, I didn't suddenly change a portion of the market from active to passive investing, I just removed an unnecessary 1.25% fee that got me nothing and did nothing positive for the economy.
[+] [-] kgwgk|7 years ago|reply
http://s18674.pcdn.co/wp-content/uploads/2015/05/Index-marke...
[+] [-] forkLding|7 years ago|reply
https://www.cnbc.com/2018/02/16/warren-buffett-won-2-point-2...
There are a lot of factors at play but simply for your non-analyst mom-and-pop investors, they don't have time and the know-how to investigate stocks and index funds are just much more accessible and as they say, in the long run we are all dead.
[+] [-] ISL|7 years ago|reply
Lots of passive money means that the market is an amplifier for the decisions of those who choose to make their own decisions. Want $AMZN to have a little more market capitalization? Buy some, and the entire market is forced to follow you. Sell some, and they will follow you, too.
It is herd behavior (which can be quite beneficial), but it affords certain advantages to those wily enough to use the herd instinct for their own designs.
[+] [-] masterjack|7 years ago|reply
[+] [-] ucaetano|7 years ago|reply
This will never happen. It might be interesting, but isn't a realistic scenario.
[+] [-] brisance|7 years ago|reply
If so, then your thesis doesn't make sense. The index fund manager's job is to maintain the fund's allocation according to the index calculation to the best of his ability, not "go out and buy some $AMZN cos it looks cheap" (which opens up the fund for civil lawsuits for not adhering to the prospectus), or to "manipulate the herd".
Tracking errors happen, but those are incidental to the need for re-balancing and are not outright actions undertaken by the fund manager for the purposes stated above.
[+] [-] blazespin|7 years ago|reply
[+] [-] jypepin|7 years ago|reply
Oh yeah? which benefits? When you know that on average, an astonishing 90 percent of actively managed mutual funds underperformed their benchmark indexes over the preceding 15 years. The index superiority was consistent and overwhelming.
I recently read the Little Book Of Common Sense Investing, and it was brilliant.
[+] [-] atemerev|7 years ago|reply
It will be significantly less popular when we hit the next recession.
[+] [-] anonu|7 years ago|reply
I take a very cyclical approach on everything. The rise of passive actually creates huge opportunities for active managers. We see this already in the ETF landscape: you can invest in any product today for very cheap. This creates a new challenge to manage the portfolio of the future. 60/40 allocations are the exposures of yesterday.
[+] [-] 3pt14159|7 years ago|reply
So long as the bots aren't conscious there will be no bot-dominated stock market. Too much information is wrapped up in conscious thought that isn't easily expressed in stock market pattern matching. The article mentions that the line between active and passive isn't as clear as people that make it out to be say it is, and that is true, but it's also incomplete. Certain events are conceivable to humans that are not conceivable to machines. Short of simulating humans, anyway.
For example, I as a human know that there is a non-zero chance that the DPRK and USA get into a nuclear war. I can know that Trump defaulting on Chinese held US debt is something that is at least on the table. The quants can try to pull in percentages from experts all they want (and they were calling my nuclear weapons arms control friends a year ago asking for percentiles) but it isn't the same thing because the model is still fundamentally concerned with statistics and many of the events we understand as humans have implicit dependence to each other that is hard to model.
It's far easier to employ a small number of smart people and have the models serve and be tuned by them than to have the models actually run everything. Plus you don't even really need them sometimes. Take Bitcoin, for example. The gains were obvious. The incentives were completely aligned and the friction was in the buy side and it was temporary. I didn't need to model out Bitcoin to buy it at $4 CAD. I just had to think about it from first principles, something that is currently not possible with ML.
[+] [-] ucaetano|7 years ago|reply
It is a self-balancing situation. A scenario of "oh my god, everyone is just putting their money on index funds" would never happen.
Another way to think about it is in terms of evolutionary stable strategy. Index funds and arbitrage-seeking reach a Nash equilibrium at some point (far more index-allocated than today's market) where arbitrage-seekers will reap returns almost equal to index funds, as index allocation starts o not capture all available market information.
If the market deviates from that point, forces push it back into that point. If the market starts over-allocating into arbitrage-seeking (like today), returns on index funds will beat arbitrage, pushing capital back into index funds. If the market over-allocates in index funds, index funds will return below arbitrage, pushing money out of index funds.
Edit: Right now, the market is still far over-allocated into the arbitrage-seeking side, resulting in a natural shift to index funds.
[+] [-] jondubois|7 years ago|reply
This represents an unfathomable about of money
[+] [-] PaulHoule|7 years ago|reply
[+] [-] arikrak|7 years ago|reply