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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#31

Post by bklyn11201 »

the_watcher wrote: post #21
godzillabrennus wrote: post #11

Earlier quoted context omitted.

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?

This is likely the best first stop for OZ info from a reputable source:

https://www.novoco.com/resource-centers/opportunity-zones-re...

The timing restrictions around OZ investments (180 days after cap gains event) make it a bit difficult and will result in lots of bad investments with non-experienced, first-time fund owners.

But maybe you have a connection to an OZ that you are familiar with and can rehab a property there. You should get help from a CPA and lawyer, but the basic process would be:

  1) Sell stock and now you have cap gains
  2) Setup OZ Fund XXX LLC
  3) Fund the LLC with your cap gains within 180 days
  4) Setup OZ Property YYY LLC
  5) Purchase property inside the YYY LLC and fund purchase with XXX LLC
  6) Rehab property within 31 months
  7) Hold for 10 years
    a) Pay original cap gains tax bill (minus 15%) in 2026 tax year (negative interest loan from gov)
    b) Pay zero cap gains on the increase in property value over the 10 years

Re: Why Index Funds Are Like Subprime CDOs

#32

Post by whatshisface »

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…

>As more and more money switches from active to passive, we have more and more money relying on less and less intelligence.

That's assuming that the mutual fund managers who are being moved away from are all contributing their own unique information to the market, as opposed to repeating textbook business analysis techniques. If the fund managers that survive are smarter than the ones being replaced by indices, the intelligence of the market will improve.

Re: Why Index Funds Are Like Subprime CDOs

#33

Post by toomuchtodo »

TheCoelacanth wrote: post #25
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.

There’s an equilibrium to be reached, for sure. The market just hasn’t discovered what it is yet.

Re: Why Index Funds Are Like Subprime CDOs

#34

Post by groundlogic »

nostromo wrote: post #24
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.

Index funds have become successful since they've performed well compared to active investment funds. Why would the active investors suddenly get better at guessing the future?

Re: Why Index Funds Are Like Subprime CDOs

#35

Post by patio11 »

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?

The more sophisticated part of the argument is that indexes require overexposure to thinly traded stocks and that in a market sell off the assets linked to the index would see outflows, which require selling the underlying(s), which would cause a material price hit in illiquid stocks, which could cause a partial feedback effect as the index would then slip more.

If one believes this to be true, one necessarily believes that illiquid index constituents are overvalued today relative to their actual enterprise value and will, at some point in the future, be sharply undervalued as a large number of computers controlling trillions of dollars attempts to implement a for loop shoveling money at you.

Re: Why Index Funds Are Like Subprime CDOs

#36

Post by [deleted] »

tjpaudio wrote: post #17
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'll try. Price discovery means finding out the value of a stock by people bidding to sell and buy it. Historically, beating the stock market is hard to do, so one strategy is to just go along for the ride, buy a little of everything. This is what ETFs do. You're not bidding your guess of the value a company should have, you are just saying "hey, I'll pay what that other guy is willing to pay". Now, thats not a probl…

[deleted]

Re: Why Index Funds Are Like Subprime CDOs

#37

Post by hindsightbias »

tjpaudio wrote: post #17
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'll try. Price discovery means finding out the value of a stock by people bidding to sell and buy it. Historically, beating the stock market is hard to do, so one strategy is to just go along for the ride, buy a little of everything. This is what ETFs do. You're not bidding your guess of the value a company should have, you are just saying "hey, I'll pay what that other guy is willing to pay". Now, thats not a probl…

Much of the market gain is around handfuls of stocks like FAANGs. And our leader has issues with 4 of those.

So there is a very closely coupled lever to the market.

I wonder if there are high speed shorts triggered by twitter already.

Re: Why Index Funds Are Like Subprime CDOs

#38

Post by neilk »

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…

I’m know I’m a dummy when it comes to economics, and an investor in index funds because of that.

But it strikes me that index funds are parasitical in a way and depend on price signals from active investors.

Some people say that it’s ok, the situation is self-correcting.

But what if the smart active money is active in places we can’t see in the public markets? Again, I’m a dummy, but I believe a lot of investment is happening privately these days.

Re: Why Index Funds Are Like Subprime CDOs

#39

Post by mattnewport »

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…

He seems to be implying that the naive idea of passive funds of actually holding a basket of the indexed stocks is not the reality and that there are various financial shenanigans going on analogous to the issues seen in the run up to the last financial crisis.

He points to a mismatch between the daily trading volume of various of the smaller components of these indexes and the amount of money globally indexed to them. The suggestion as I understand it is that some of the indexed money is not directly holding the indexed stocks but is using financial instruments to track the indices indirectly and that in the case of another global financial crisis those instruments could break down and you'd potentially see significant divergence between the tracking funds and the actual indices.

That's just my layman's interpretation though, I'm not an expert on this stuff.

Re: Why Index Funds Are Like Subprime CDOs

#40

Post by jorblumesea »

There are ways to get more diversity within indexing itself. eg: small cap index, value index funds. It seems like the bone of contention is that indexes track the entire market based on trading volume, and that is an existential risk given cap weighting. Many now invest in total market indices, which limits the impact of large cap companies. The "cap weighting" problem is a known issue in indexing and this is why you invest in total market, small cap, mid cap indices.
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