But then I had the question: When the world has gone passive, who is left as an active investor?
1. Wallstreetbets users who do poorly on average, and they are small
2. Highly skilled Hedgefunds like Medallion who do great on average, but they are small
3. ... the company using debt to buyback its own shares
So the key behind this entire stock market is that its a beauty contest where you need to make guesses as to what everyone else will do. But as active investors shrink with the increase in passive, what we are allowing happen is that the companies who use debt to buyback their shares are whats driving the market. Every dollar they spend on their stock is then magnified 100x by the big passive funds, and both 1 & 2 have no agency other than to try to get swept up in the winds.
I have not yet done the intensive research to understand how large 3 can effect a stock, does anyone here have any idea if this will be a problem, and if we are already seeing signs that this is happening already?
The thing is that I'd rather be doing other things with my time, so I'm a passive investing kind of guy. Imagine getting the market return for doing nearly nothing for dirt cheap. That's a high growth rate to level of effort ratio!
But I think a key point is that active investing already exists and dominates the market -- it's still like 85% active. People choosing to invest in passively managed funds are doing so because they see a higher return. Maybe the choice is sticky and people won't switch back if the returns begin to fall, but people still have to switch in.
So building up a surplus of passive investors requires people to continue to switch to a passive strategy after the returns between passive and active level out and reverse. And not just a little -- profits from investing are returned to investors, and reinvested. So if the equilibrium between active and passive investing is X% of the market passive, and we get up to passive investors at X+10% of the market, then the X+10% of passive investors will see a lower rate of return than the 90-X% of active investors. Which means -- unless those active investors take their surplus profits and dump them into then-less-profitable passive funds, before long the active investors will have 91-X% of the market and the passive investors will have 9+X%. Absent continued switching, the feedback of profit re-investment will push the balance back to equilibrium.
A market is "too passive" when it becomes exploitable due to perfect predictability. But - that is the very thing that will keep it from ever reaching that level of passivity. Exploiting it is an active step, then someone else bets against the exploiter, etc.
I've always found stock buybacks intriguing and confusing. Here's a hypothetical scenario that seems to go against what you're saying:
Company A buys back $1 work of stock. Since there is now $1 less in Company A's bank account, that company is now worth $1 less. So the market cap should in theory be $1 less. Since the market cap should be $1 less, and $1 of stock disappeared, those perfectly balance out and mean the stock price should stay the same.
Now the index investors take a look at the situation. Company A's market cap has shrunk, whereas other companies' market caps haven't. So Company A has a smaller share of the index than other companies than it had before. But the index investors still have the old ratio of Company A to other companies, so they are overinvested in Company A. They all sell a bit of Company A in order to get the correct balance according to the index. Company A goes down in value.
So a stock buyback caused the price to go down.
When you do a buyback, the book value drops (company loses cash), but the discounted future cash flows remains unchanged. The number of outstanding shares also drops.
The net result is the stock price increases as a company accumulates cash and uses it for buybacks because the number of outstanding shares drops.
Another way of thinking about it is that it's the same as dividends, but the dividend only goes to the sellers of the stock during a buyback.
The whole book value + discounted future cash flow does not reflect the real stock exchange at all. If that was the case no investor would want share buybacks because as you say it would only reward the ones who sell...
When taking into account offer and demand stock buybacks make more sense: the buyback increase the demand for the stock. The offer will increase a bit (a few might sell) but not in the same proportion because the offer is not very elastic (most of your investors are in for a long ride and are not going to sell), so the price goes up, you get rid of some short term investors, and the long term investors see their share increasing in value. Everybody's happy and the dividend ratios do not mean anything anymore.
Initially:
market cap = $100
book value = $20
discounted future cash flows = $80
share price = $1
number of outstanding shares = 100
After the buyback:
market cap = $99
book value = $19
discounted future cash flows = $80
share price = $1
number of outstanding shares = 99
So the market cap didn't change.
I agree it's effectively the same as dividends (although I think buybacks are slightly better for the taxes of stockholders).
He goes into a lot of data around the idea that the market is "too passive", and he believes that we were already at that point last year before the pandemic.
Medallion usually does well, but hedge funds underperformed in the 2010's.
That's a bit of an understatement. The lowest yearly return since 1990 after fees and expenses has been 20%. Since 2005 their lowest yearly return has been 29%.
They practically print their own money. Their strategies appear to have low capacity, I'll give you that.
The best example is Berkshire Hathaway stock (BRK A share) which currently trades at $402,620 per share.
For more recent (and much more technically difficult) treatment, you can take a look at Garleanu and Pederson (2018) ("Efficiently Inefficient Markets for Asset and Asset Management").
Passive investors who only invest in the S&P 500 didn't enjoy the ride up. But there are plenty of other indexes that people invest in passively that would have held TSLA prior to being added to the S&P 500.
I own SCHB, for example, which tracks the Dow Jones U.S. Broad Stock Market index, and would have owned shares in TSLA long before it was added to the S&P 500.
Simplest example I cited already: it becomes obvious that company X will default in short order, but it's a member of an index and the market will "buy" it anyway: I can short it (by borrowing from the passives and selling it to them next time they buy the index) and never have to cover since it's bankrupt. That's a simple example of a single-player active skewering the passives.
You can try to figure out what this means in terms of tracking error but it's kinda irrelevant to my point.
In the world as it stands today, passive ETFs and index mutual funds are a huge source of shares to lend. It's one of the ways they can lower the cost of the passive fund (or slightly increase returns above the passive benchmark), as the proceeds from lending shares are returned to investors in the fund. (Not always, but the good ETF operators do this.)
That said, I as a buyer-and-holder, I welcome the hordes of active traders willing to expend time, effort, and money to discover the price that I too will be able to trade at.
With more and more assets going into passive funds, when might we actually see them owning such large fractions of companies that a play like this is possible? Google suggests that 10-15% of the SP500 is owned by mutual funds. Presumably there's going to be an inflection point where this becomes problematic.
Index funds need to rebalance so they’re not just holding, but it seems like for passive investors, they approximate holding? Maybe the rebalancing would tend to exaggerate the effects of active trading?
Reverse how? There are so many axis I don't know which to use as the basis of my flip. If you care to, please explain a bit more in detail.
But, sure. Let's say I know that you (index fun) are obligated to buy stock X tomorrow and over all foreseeable future. I am gonna hoard those shares at no risk and sell them to you at a VERY VERY painful price, since you have no room to say "that's too expensive, no thanks"
source: Any prospectus/annual report of a large index fund, such as VTI.
No, actives can make money on average. If the actives do expensive research and learn things, they can buy good stocks at low (below-fair-value-given-new-knowledge) prices, drive up the price, and the passives follow later, buying at high (fair) prices. No one needs to lose, but actives accrue a disproportionate fraction of the gains.
> This breaks down if passives outnumber actives
Hypothetically there is a level of passive investing where the system breaks, but (1) this has nothing to do with 50% threshold (a small active minority can be fine) and (2) the are natural strong forces that prevent this from happening (as the fraction of passives increases, the reward for being active increases, drawing in more actives).
There will always be a mix of active and passive.
Fundamentally - passive only works when it follows smart active. Actives do expensive research and trade against each other to arrive at the consensus price. Passives trade at that price for "free." Since both get the same price on average but passives incur no cost, they win on average
This breaks down if passives outnumber actives, or if actives are exceptionally stupid.
Imagine 100% is passive. That means any stock in an index will be bought tomorrow and forever regardless of price. I could exploit that in a ton of ways. For example, do a "squeeze" (think of the recent GME short squeeze but in reverse.)
Or, imagine company X will obviously default but stock keeps going up because passives are obligated to buy. Very easy to exploit by going active!
Finally - think about this. Does your index fund have any GME? That part of your portfolio trades at the price set by Reddit apes. The more of that goes on, the more tempting it is to go "active" on the other side.