Can you expand on what exactly that means?
1) http://siblisresearch.com/data/total-market-cap-sp-500/ 2) https://www.fool.com/investing/2017/02/26/warren-buffett-jus...
If the majority of the market is passively rebalancing, does the true value matter or does the weighting swamp it?
I see how one would make money on arbitraging pre- and post-90s mandatory rebalancing by major passives. I'm less clear on how one arbitrages difference between the prices passives are investing at and a "true" price.
If the market is systematically over-pricing companies, you create a private company and then take it public to cash in on the inflated prices. If the market is systematically under-pricing companies, you buy up a company for less than it is worth, and then run it as a private company for profit-making purposes.
What does that mean?
Perhaps A is large caps, B is small caps, and C is metals, it don't really matter for the sake of discussion.
You started off with purchases equal to your 33% 33% 33% goal ratios but after a year of unequal growth you're overweight C and underweight A.
Active rebalancing is selling enough C and buying enough A to get roughly equal ratios of A:B:C.
Passive rebalancing is if you're contributing $5K IRA per year or whatever, dump all your contributions into underweight A. Or whichever is underweight at any time.
Basically if your position ratios don't match your goal ratios, if you're selling thats active rebalancing and if you're merely changing the ratio of what you buy because you're a net investor thats passive rebalancing.
Going back to the real estate analogy dumping money into purchasing a lot in a gentrifying neighborhood is an analogy for passive rebalancing. If you sold your best performing property to fund it, that analogy would be active rebalancing.
Depending on the weighting method of the index you're tracking (and other indices that include your stocks), the indices need to rebalance purely in response to "price changes happened and reallocation is needed."
This requires buying at minimum (or buying and selling as VLM pointed out). That buying moves the market when there's a significant amount of money in index following funds.
The initial comment was about reaping arbitrage when (I think) the price the index following funds made diverges from the actual (ex index involvement) price.
I was wondering how that's operationally relevant or whether the "Don't fight the Fed" rule comes in, given that there's a massive amount of money in index funds.
Someone with more knowledge would have to chime in as to the effect in aggregate of rebalancing playing against active moves (for fundamental reasons).
I think the relevant mispricing introduced by passive investing is the relative one. The question is not that passive investors are driving the S&P 500 index higher than it should. The thing is that they are failing to distinguish company A, which should ouperform because it's doing well, from company B, which should underperform because it's not doing so well.
Sure. But it's unclear where the equilibrium is between the volume of passive investing and the volume active investing (or if there is one).
In the meantime, the increasing share of passive investment is causing the prices on all these assets to become more correlated. This increases systemic risk. When everyone diversifies completely, you lose the benefits of diversification.
It's unclear to me how well investors recognize this shift in systemic risk. Obviously there will always still be some active investors. But how can you be sure that the economy won't be destabilized from this?
So the momentum of the idealogy has shifted from people trying to beat the market to people throwing up their hands and following heuristics. The larger the momentum of the heuristic the more robust it is. (Which is bad, in an antifragile vs robust sort of way)
To use a real world example, you could say that the overall restaurant industry is vibrant only because individuals naively underestimate the difficulty in starting one. The naive trying is what produces a competitive landscape that discovers 'quality'.
Similarly, the naive trying to get VC capital (despite the majority of ideas not having the scale/growth potential needed to fit the VC model) creates a vibrant technology and new-lifestyle scene.
So during a momentum re-stabilization phase, it's possible that the truck topples over the railing instead of back onto the road. Also, the overall reduction in number of individual of thinkers also increases the impact of bad-faith agents in positions of unfair leverage.
Retail investors don't act as a rational pricing mechanism. 99% of them don't discount future cash flows, examine balance sheets, or evaluate growth prospects. In fact they statistically buy high and sell low which only serves to make boom and bust cycles more severe. They are the greater fools in the Greater Fool Theory.
Turning "dumb" retail money into passive index fund flows can only serve to make markets more efficient and stable. That said, if I had to guess the massive flows to index funds will come to a grinding halt as soon as the next market correction.
While indexing has historically been the best strategy over the long run, the low interest rate environment has made it appear to be the best strategy even in the short term. This is not normal and is due to the high correlation still lingering after the effects of QE. Once interest rates rise enough to make alternatives more appealing this will balance itself out since investors chase returns.
Generally you should avoid putting money into stock markets with anything less than a 10 year window unless you love risk. And you should never put your emergency fund in the stock market since stock market crashes and needing said emergency fund tend to be highly correlated, which means when you pull your money out, you are all but guaranteed to be selling low.
[0]http://www.investopedia.com/terms/c/capm.asp [1]http://www.investopedia.com/terms/e/efficientmarkethypothesi...
I invest in their S&P 500 ETF because it's the cheapest way to get diversified exposure to the 500 largest American companies, and I believe that the 500 largest American companies will be more valuable in the future as a combination of valuation, scale, and cash flows to owners, than they are right now.
I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. So even if the EMH is false in some broad sense, individual investors should act as if it were true and simply invest in low-cost diversified funds.
In the next breath you say that even if the EMH is false "individuals investors should act as if it were true".
This makes your post somewhat ambiguous; not so clear about which position you're advocating. How "plausible" is it that these managers are "impossible to identify ex ante."? Why is it plausible? "Impossible" seems like a pretty strict standard (akin to strong EMH), why not just say instead that identifying such managers before they outperform is "practically impossible" or just "really, really, damn hard and something that you're deluding yourself about if you think you can do it."
Also (assuming it is your position), it's important to clarify that you don't disagree with the assertion that many people do identify market-beating managers before they outperform. Probably millions of people have done it; it happens every day. What they don't do (in my opinion) is use skill or knowledge to identify the outperforming managers. If they do identify an outperforming manager (of which there are always many) it happens because of chance or luck. (Just as, IMO, the outperformance itself of almost all outperforming managers is due to luck or chance, not skill.)
Yet we know that hiring for programmers is utterly hopelessly broken beyond all belief, industry wide.
Therefore its very unlikely that people of a similar cognitive and training level that utterly failed at hiring programmers could possibly select outperforming investment managers given that being an even more difficult job. No one in HR or management is going to be selecting outperforming investment managers.
Its possible that someone outside HR and management is better at selecting the best programmers. Certainly plenty of advice from outsiders is given to hire more of coincidentally highly politically correct demographic group A or group B. Or perhaps ivy college admissions officers magically know how to pick future great programmers (LOL). Professors and college advisors might put forth a weak argument in their own favor. Still, money seems to talk and greed means management and HR, however awful they are at selecting programmers, none the less are the best skilled at it, regardless how low that skill level is.
(And yes, I understand that you agree with the conclusion there. But I'm saying what's the point of the verbal gymnastics in the first place?)
I think this is the kernel of what Bogle was saying and Vanguard is now reaping the benefits of.
Old system: active traders beat the market, therefore they charge fees slightly less than the alpha they're supposed to generate
New system: customers are more aware that their active trader(s) may not be the winners, so the acceptable fee to pay the traders decreases to the product of the alpha AND the risk of not picking the right traders
https://www.zacks.com/stock/news/250937/warren-buffett-on-ac...
Why would they? Unless they're so rare that there are only a few of them, one would expect the market to encourage "fair" pricing of active management--yet a key dogma of passive investing is that the market is generally efficient, but the market for actively managed mutual funds isn't!
It seems more plausible to me that (handwavy):
1. People can, in fact, beat the market, with lots of effort (e.g. very large college endowment funds, which outperform smaller ones, presumably by spending more on management and research)
2. The barriers to entry are typically high (because most investors won't trust their money with someone with an unproven track record)
3. Those high barriers to entry both allow the few established genuinely successful fund managers to charge higher fees than otherwise (to your point, eating up the alpha they generate) and ensure that "managing a fund" requires good sales skills and not just good management skills (see, lots of hedge funds)
Or, in short, lots of markets are inefficient--both the stock market and the market for managed funds. But because the stock market is much bigger than the fund market, it's probably _less_ efficient. Or so we hope.
This isn't how causation works.
> A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees.
It is as much work to identify good fund managers as it is to identify good company managers. You might as well save some money if you go this route and invest in a portfolio of companies directly.
> Furthermore, a smart manager will charge fees that are equal to the alpha they generate.
Warren Buffett seems quite smart, I mean he made it to rank #1 on the world's rich list and I think he's one of the few on the top #100 that did it by investing in other companies rather than just building his own. Judging from his 40 year performance data he's generated rather more alpha than any other manager. He charges fees that are very close to 0.00001% for being a partner with him.
That would seem to contradict your point.
Or maybe he just believes the market might stay irrational longer than he can stay solvent.
My concern is that if everyone is in the passive investing boat then we're no longer following the market, we're making the market, and it's a big departure from the philosophical under-pinnings behind the idea of passive investing.
(We started out letting active players make the market by placing good/bad bets and winning/losing. We got a market that was at least trying to find the right price and we did well due to the low expense ratios. Now that we're in the majority, I'm concerned that no-one is trying to find the right price anymore.)
tldr; I have mixed feelings about passive investing over the long term if we're no longer small fish in a big ocean.
EDIT - I highly recommend watching some of Robert Schiller's Financial Markets lectures on Yale Coursera about general investment theory. Bogle is saying good things, but he simplifies it in a way that I can see might sound disconcertingly incomplete. You're not wrong to ask these questions if you're conscientious and smart enough to want more in-depth answers.
Obviously, these are edge cases (we'll never be 100% passive), but there is some concern that there will be a lock-in effect for companies currently in the S&P... It will be harder to grow if you're not in it, and it'll be harder to fail if you are.
There's also no reason why passive indices have to reflect the total market weighted for market cap.
[0]https://corporate.morningstar.com/US/documents/MethodologyDo...
- http://www.investmentnews.com/article/20170224/FREE/17022994... - https://equityzen.com/blog/alternatives-part-of-investment-p... - http://video.cnbc.com/gallery/?video=3000598150
Disclaimer: Links #2-3 are affiliated with my own company, so you should decided whether or not to believe me.
I'm intrigued by your suspicion ... but I can't put my finger on the exact manner that this might play out ... it's really hazy.
It seems to me that the effect of everyones money going into index funds would be that firms large enough to be in the index would have less and less pressure to issue dividends ... if there is a ready market of buyers of your stock based solely on your size then why bother ?
If money flows, by autopilot, into an asset class wouldn't we expect that asset class to return less and less as time goes on ?
Yes, there are some IPOs, but overall new business starts are still in decline, and large portions of financial markets seem both too systematically risk averse, and yet willing to follow other risks blindly.
The problem is deeper than that. Active shareholders actually give a shit about corporate governance. Collectively, they put honorable and competent people on the board of directors, and make sensible decisions when other issues are put to shareholder votes. Vanguard and other indexing funds could barely care. Their incentive to care is so small, we may as well call it nothing. Whereas the employees who control these voting blocks at Vanguard can easily make decisions that cause 10,000x more financial impact than their total compensation. And whenever someone is endowed with such power, human behavior throughout our existence has shown most people will be corrupted by it (e.g. see government employees).
> Still, these funds retain the power of voice, the ability to exert shareholder influence on management and governance-related proposals. But critics say passively invested funds, with their lower fees, lack the resources and often the will to monitor their large and diverse portfolios. The Economist calls them “lazy investors.”...
> My fellow researchers and I set out to test that claim. In our forthcoming research paper in The Journal of Financial Economics, we show that passive institutions do indeed positively shape firms’ governance policies. Our findings run contrary to the presumption that passive investors lack the willingness and ability to influence firms’ policy choices.
> The results of our analysis suggests that passive investors affect firm governance in several ways. For example, we found that an increase in passive ownership is associated with a statistically significant increase in the share of independent directors on firms’ boards. In addition, firms with higher passive investor ownership were more likely to remove firm takeover defenses (for example, so-called “poison pills” and limitations on shareholders calling special board meetings). They were also less likely to have the unequal voting rights of a dual-class share structure.
[1] https://hbr.org/2016/05/research-index-funds-are-improving-c...
Also, I would counter that in a firm, the legal and immoral loopholes that would give one party greater wealth would do so 1) at the expense of other parties inside the firm and 2) run the risk of bad optics / PR to institutional investors who look out for things like this when evaluating a firm.
Lastly, the aggregate of these factors is baked into the return on investment of a stock. In other words, I suspect that might be happening in firms that are making alot of money and providing healthy returns for shareholders. Alot less so at firms that are struggling and not providing much growth.
For instance, at the 2016 Alphabet meeting, they voted for Alphabet shareholders having one vote per share and adoption of a majority vote for election of the board. Those are the very core corporate governance oddities that Alphabet is using to allow the founders and Eric Schmidt to have total control of the company and Vanguard voted their shares towards better governance.
Obviously, since Eric Schmidt and the founders have the majority of the votes, these didn't pass, but they voted the way you would have liked and against management.
Tell me what you think the result of this scenario might look like. A manager wants to conduct an LBO that grossly undervalues a stock. He couldn't get the votes from shareholders if they were paying attention, but instead he walks up to management at Blackrock, Vanguard and State Steet, and offers the people in charge of voting a very lucrative job at the new private company. How do you think they'll vote?
I think a better approach would be to pass through voting to the owners, but given that most shareholders don't know enough for their vote to be more than a random guess, that wouldn't much solve the problem, either. But at least the people who are affected by the decisions being made are the ones making the decisions.
I don't understand why that would be the case. Just charge a flat fee for the fund and distribute proportionally to the teams whose companies do best.
It sounds impossible to satisfy your desiderata with unsophisticated investors. They will have to delegate the task of assessing board decisions to someone.
While Vanguard may vote all their shareholder proxies, they almost always vote along with the recommendations of management - practically never holding management accountable.
Proof: Take a look at their actual voting record on the S&P 500 fund https://about.vanguard.com/vanguard-proxy-voting/supporting-...
It is a huge problem (and probably responsible for much of the lawlessness we can find on Wall Street), but the switch from active to passive investment shouldn't change a thing.
No big fund manager has enough skin on the game. That has been true for most of last century and all of the current one, and the expected results are visibly there.
I don't believe this. They bring in axemen to cut jobs for a bump in stock price. For one, why do they allow for huge severance packages even when they fail?
His job isn't to make and sell cell phones. His primary function is to make the C-suite accountable to shareholders. The C-suite's job is to make and sell cell phones.
Frankly, Boards function mostly on business metrics and people skills that are generic to any business.
He has a working knowledge of how governments operate, and as such knows the right person to call and the right procedure to follow to get stuff done. He probably also still knows a bunch of people whom could be useful to know if you're operating a huge multinational company.
If that happens, you end up with resources such as labor being wasted. The efficient usage of the available resources is of course a much better indicator for the quality of the economy than the rise of stock prices.
I can't see why this is any kind of danger. Companies end up subjectively with "too much capital" all of the time in this market without being part of a large index. Look at tesla.
The more risky effect is that all stocks in an index become more correlated with it over time, leading to larger jumps in single names around earnings seasons when real information is released to the public.
If these passive investment funds create a positive feedback loop for some stock prices - I don't know if that's the case - then this could be a pretty high risk.
On the other hand, I would intuitively expect them to have a dampening effect on the "pump and dump" schemes that created so many bubbles. So, in a way, they could even help stabilizing the markets?
That won't happen (probably).
The less accurate our concept of correct value is, the more competition it will draw as the margins increase.
Realistically, we can be probably something absurd like 80% passive funds and 20% active investors and be fine.
I think you underestimate the size of the active players in the market, especially considering leverage, which they generally are to the hilt.
Vanguard is not nearly as active is most mutual funds, but they are not entirely passive either.
Vanguard has lower costs because it employs fewer people to execute fewer trades. That's all I really care about.
Could that be mitigated by people not completely jumping on the passive bandwagon (e.g. by keeping say 5% in active funds)? Wouldn't all that you need is an active enough and large enough market to resist manipulation?
The outflow is mostly from active domestic equity mutual funds (average expense ratio: 1%-1.5%) to index domestic equity ETFs (average expense ratio: 0.1%-0.2%), so it's really about lower costs and the relative underperformance of active management.
Active managers go around with the notion that as they die off to be replaced by index funds, that there there will be no price-finding.
But here's the thing - before managers, and before mutual funds, most people were buy and hold investors. There was very little "price discovery" compared to today, as most stocks sat on a shelf (literally, as people had paper certificates for the shares they owned).
In that world, the price discovery function was quite small, but clearly adequate.
Today, there are many highly-paid managers who "actively" manage money. ( I challenge the "actively" portion, because many are closet-indexers. If you google "active-share", you can find more about this.) But even if they aren't closet indexers, in any given year, most cannot beat their benchmark. When they can't beat their benchmark (which, ironically is an index), they are inefficient.
That statement bears some emphasis - When Active managers cannot meet or beat their benchmarks, they are __REDUCING__ the market's efficiency. Put simply, they were wrong on what they thought the correct price should be, thereby hindering price discovery.
Read that last paragraph again - it's extremely important. Also, note that there are many people on Wall Street who are highly compensated, and afraid that their jobs will go away because of indexing (note that the S&P 500 is only one index - there are hundreds of others, including MSCI and Russell indexes). They are right to be concerned. After all, as in anything in life, if you can't keep up with the benchmark, you will get cut. This happens in professional sports, people in college with poor grades, and anybody in a sales job. And it's been happening in finance since before any of us were born.
One final note: Back in 2001, the US markets moved from fraction pricing to decimalization. In short, the price increments went from 1/16 of a dollar to 1/100 of a dollar (i.e. a penny). That's a six-fold improvement in pricing accuracy. To think that having less active money will destabilize our economy is unfounded.
If I recall correctly (and again, it's been a while), I think the amount of passive funds has to be quite substantial for markets to be really bad at reflecting value over the long run.
If investing decisions get slower in general, then I think it would be a good thing. The number of company decisions made only for only the next quarter rather than long term profitability would be much less if it took time for people to switch the companies they invest in rather than doing so instantly, which would in turn make a more efficient and stable market.
As more shares of a company are held by passive investors, the fewer are available to trade on a daily basis, right?
At no point did I think the difference in inflows was anywhere close to 8.5x. And it does worry me.
I'm familiar with the contention that even having some active players in the market will arbitrage the prices back to fair value, but when they compose such a small share of such a large market that's no longer a trustworthy assumption to make.
There's no law that I know of that prevents active players from exploiting the knowledge that passive money will go wherever the market tells it to. There have got to be a lot of opportunities here for profiting, legally, at the expense of those passive investors, that goes beyond simple margin arbitrage.
My point is, the less active money there is around, the less accurate our concept of a correct value can be. This situation has the potential to de-stabilise the economy sooner rather than later.