Why Index Funds Are Like Subprime CDOs • Hacker News Board

Re: Why Index Funds Are Like Subprime CDOs

#41

Post by yifanl » Wed, Sep 04, 2019, 5:11 PM UTC

groundlogic wrote: post #34

nostromo wrote: post #24

Earlier quoted context omitted.

> 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?

Because when enough of the money is in an index fund, you can predict how a large part of the investors are going to invest (using the same algorithms they're using) and adjust based on that.

Re: Why Index Funds Are Like Subprime CDOs

#42

Post by abakker » Wed, Sep 04, 2019, 5:11 PM UTC

toomuchtodo wrote: post #33

TheCoelacanth wrote: post #25

Earlier quoted context omitted.

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.

I am not an economist either, but it seems that there is a danger in assuming there will be an equilibrium. I think it is entirely possible that there won't be one.

If there is an equilibrium, it may take a significant price shock to discover where it is. I.e. that equilibrium could be years behind us, and if there is a crash we might never recover the value that our current market assumes is there.

Re: Why Index Funds Are Like Subprime CDOs

#43

Post by lunchables » Wed, Sep 04, 2019, 5:12 PM UTC

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…

Thank you, this clarified so many things.

Re: Why Index Funds Are Like Subprime CDOs

#44

Post by lordfoo » Wed, Sep 04, 2019, 5:14 PM UTC

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…

> This is what ETFs do

ETFs aren't necessarily index funds

https://www.forbes.com/sites/rickferri/2014/01/16/etf-does-n...

Re: Why Index Funds Are Like Subprime CDOs

#45

Post by perardi » Wed, Sep 04, 2019, 5:14 PM UTC

neilk wrote: post #38

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…

You are not a dummy. Over the past 30 years, index funds have outperformed active management, especially when you consider the fees.

You are a ”dummy” in the sense you don’t have perfect information awareness on every possibly tailwind or headwind that could impact a particular stock. But everyone is a dummy in that sense.

Re: Why Index Funds Are Like Subprime CDOs

#46

Post by pwthornton » Wed, Sep 04, 2019, 5:15 PM UTC

Isn't a big part of the issue with actively managed funds the fees, which usually wipe out any gains above index funds. Wouldn't the market correction be to close the delta in fees between active and passively managed funds to encourage more people to go the active route?

A lot of the grousing about passively managed funds come from people who are running actively managed funds that charge huge fees to under perform passive management. By lowering fees, actively managed funds should be able to do a better net and to be able to attract more investors.

Any sort of government solution to index funds getting large would basically be protection for these actively managed funds. There are actively managed funds that can beat passive funds, but it's incredibly difficult to do so when you charge a 2% fee.

Re: Why Index Funds Are Like Subprime CDOs

#47

Post by lunchables » Wed, Sep 04, 2019, 5:15 PM UTC

southphillyman wrote: post #28

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.

Aren't most of those double digit gains just from the market rebounding from the 2008 recession?

Re: Why Index Funds Are Like Subprime CDOs

#48

Post by chad_strategic » Wed, Sep 04, 2019, 5:15 PM UTC

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?

First and only piece of advice. This probably isn't the forum to get investment advice.

:)

Re: Why Index Funds Are Like Subprime CDOs

#49

Post by groundlogic » Wed, Sep 04, 2019, 5:15 PM UTC

yifanl wrote: post #41

groundlogic wrote: post #34

Earlier quoted context omitted.

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?

Because when enough of the money is in an index fund, you can predict how a large part of the investors are going to invest (using the same algorithms they're using) and adjust based on that.

Kinda makes sense. Still, it sounds like a very fragile system.

So instead if active fund managers "knowing the market better", we'll get active fund managers, "knowing the passive investor crowd better".

This is madness.

Re: Why Index Funds Are Like Subprime CDOs

#50

Post by noirbot » Wed, Sep 04, 2019, 5:16 PM UTC

groundlogic wrote: post #34

nostromo wrote: post #24

Earlier quoted context omitted.

> 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?

I'd assume there's some stability to knowing that X% of the market is passively invested in indexes. It could give active traders some extra edge, since it would make things more predictable? If everyone's an active trader, it's everyone competing against everyone else, where everyone is a live actor. On the other extreme, if you're the only active trader, and literally everyone else is in indexes, you'd be the only person actually moving the market in response to news, and could use that to your advantage.

Obviously we're not in either state, but presumably the closer we get to the latter state, the game gets a little easier for the active traders, not that that necessarily means they'll get a free "win"