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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#21

Post by the_watcher »

godzillabrennus wrote: post #11
spenczar5 wrote: post #5

He says he's (reluctantly) doing active stock picking. He's a professional investor; I'm just some software engineer with a nest egg, which is 100% in index funds today. What should I be doing, as a schmoe who wants to save money?

Take a look at opportunity zone funds today. You can pull your money out and pay zero capital gain taxes for seven years. Then get a 15% discount on your capital gains at that time. All returns you realize from the fund are capital gains tax free. The benefits end this year.

I know a bit about Opportunity Zones (roommate bought property that was subsequently designated one, to his delight), but not about the funds. Do you have any particular recs on where I can read up on them?

Re: Why Index Funds Are Like Subprime CDOs

#22

Post by davidw »

kybernetikos wrote: post #19
throwaway713 wrote: post #4

Can someone who understands investing well explain what he’s saying in terms that someone who isn’t knowledgeable about this could understand? I kind of think he’s saying that everyone is just shoveling their money into index funds without thinking about it and this leads to incorrectly valued stock that will correct in the form of a crash at some point. Is that sort of the gist of it?

I think the contrast is between active and passive funds. If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets. A passive fund adds money into the system, but it doesn't add any intelligence - it relies on the intelligence of the current market participants. As…

> This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds start to make more money than before.

This makes sense to me - I would see returns to active investors increasing gradually, as there are fewer of them. At which point, more people take their passive investments and give them to the active investors. At some point you maybe reach some sort of equilibrium.

Why would it not be a well-functioning feedback loop like this?

> If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets.

Also, worth noting that it's beneficial for the market, not necessarily (and probably not likely) for the individual investor, who will pay higher fees and may underperform the market.

Re: Why Index Funds Are Like Subprime CDOs

#23

Post by bklyn11201 »

Peej255 wrote: post #2

If true what's the hedge? Pension and investments to cash and bonds? Japanese stocks?

The hedge to a portfolio full of heavily-indexed stocks would be fairly-valued, non-indexed stocks. Burry had to report his holdings in a 13F filing on August 14:

https://www.sec.gov/Archives/edgar/data/1649339/000156761919...

He holds heavily-indexed companies like Disney, Fedex, and Alphabet.

He holds a couple of small-cap value companies that aren't likely to be included in more than a couple of small ETFs: Tailored Brands (Mens Warehouse) and Sportsmans Warehouse.

Re: Why Index Funds Are Like Subprime CDOs

#24

Post by nostromo »

groundlogic wrote: post #3

Not an economist, but it's obvious to anyone used to thinking in terms of systems that index funds can't work after a certain amount of the money poured into the system is managed by index funds. What's the limit - 30% 40%, 50%, 60%? What's the current level in terms of managed capital? (Edit: https://www.cnbc.com/2019/03/19/passive-investing-now-contro... says 45% for US stock-based funds, half a year ago, so maybe…

> index funds can't work after a certain amount of the money poured into the system is managed by index funds

That's not true. They'll still function just fine.

What will likely change is that they will begin to underperform other strategies, including different types of indexing and active investing.

At that point the market will self-correct and simple indexing will fall out of favor.

Re: Why Index Funds Are Like Subprime CDOs

#25

Post by TheCoelacanth »

groundlogic wrote: post #3

Not an economist, but it's obvious to anyone used to thinking in terms of systems that index funds can't work after a certain amount of the money poured into the system is managed by index funds. What's the limit - 30% 40%, 50%, 60%? What's the current level in terms of managed capital? (Edit: https://www.cnbc.com/2019/03/19/passive-investing-now-contro... says 45% for US stock-based funds, half a year ago, so maybe…

It should be self-regulating, though. The higher the portion of the market that is passively investing, the easier it should be to beat their returns by actively investing so the more incentive there will be to actively invest.

Re: Why Index Funds Are Like Subprime CDOs

#26

Post by _bxg1 »

kybernetikos wrote: post #19
throwaway713 wrote: post #4

Can someone who understands investing well explain what he’s saying in terms that someone who isn’t knowledgeable about this could understand? I kind of think he’s saying that everyone is just shoveling their money into index funds without thinking about it and this leads to incorrectly valued stock that will correct in the form of a crash at some point. Is that sort of the gist of it?

I think the contrast is between active and passive funds. If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets. A passive fund adds money into the system, but it doesn't add any intelligence - it relies on the intelligence of the current market participants. As…

Where do robo-advisors like Betterment fall into this? It seems like they combine a variety of different funds; do they typically stick with only passive funds or a mixture?

Re: Why Index Funds Are Like Subprime CDOs

#27

Post by 0xDEFC0DE »

throwaway713 wrote: post #4

Can someone who understands investing well explain what he’s saying in terms that someone who isn’t knowledgeable about this could understand? I kind of think he’s saying that everyone is just shoveling their money into index funds without thinking about it and this leads to incorrectly valued stock that will correct in the form of a crash at some point. Is that sort of the gist of it?

Someone that knows more than me: how is a correction going to happen on index funds?

Retail investors are told to shovel money in and keep it there. Who's going to be selling to pop the bubble? Do investment banks have a lot of index funds and their derivatives bought? Does there have to me some major re-allocation within the fund that causes investors to sell?

If a single stock is valued incorrectly, how is that going to bring down the entire index?

Re: Why Index Funds Are Like Subprime CDOs

#28

Post by southphillyman »

Timely article, I was just thinking about this last night...while browsing Vanguard's site looking for index funds to invest in. Everyone blindly putting their money into similar instruments and getting double digit gains nearly every year just seems like it can end catastrophically. I want to do more research on how these passive funds affect the overall market and vice versa.

Re: Why Index Funds Are Like Subprime CDOs

#30

Post by dcolkitt »

throwaway713 wrote: post #4

Can someone who understands investing well explain what he’s saying in terms that someone who isn’t knowledgeable about this could understand? I kind of think he’s saying that everyone is just shoveling their money into index funds without thinking about it and this leads to incorrectly valued stock that will correct in the form of a crash at some point. Is that sort of the gist of it?

Other replies were good. But I'll add my two cents.

Index investors are basically free riders off the information and research generated by active investors. Indexing basically works pretty well because the market's efficient.

An index investor just comes in and just pays whatever the current market price is and allocates in proportion to whatever current market valuations are. He doesn't even need to know anything about the underlying companies. "Microsoft? Never heard of it. But the market says it's worth 3.8% of all major American stocks, so I'll put 3.8% of my money in it"

Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.

And the reason it does work is because the active managers compete so fiercely with each other. They end up showing all their cards to the market. And all the information they have, and the research and the analysis winds up reflected in the publicly available stock prices. In effect active investors pay their managers big fat salaries to analyze stocks, and passive investors get nearly all the benefits without any of the costs.

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