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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#61

Post by FabHK »

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?

In my view there are two take-aways from this: 1. Diversify, but 2. not too much.

1. Even among index funds, maintain some diversification. Don't put all in US large caps (S&P 500), but also some international and some small caps (Russel 2000).

He is saying that given how much money is invested via index funds now, there are opportunities in assets that are not (or insufficiently) represented in index funds. (This is hard, though, and the standard advice to refrain from trying and placing your bets on index funds instead remains valid, I think, particularly for mature markets in which you don't have an edge.)

The second take-away is at a tension with the first:

2. Avoid ETFs that handle illiquid assets (real estate, bonds, etc.) or create synthetic exposure using swaps and derivatives.

For big, liquid assets, the ETF or index fund can just take the investor money and go buy the assets. Then the value of the fund is approximately the value of its constituent assets, sort of by definition, and that value is relatively easy to realise (that is, if you want your money back, you get it - they'll have to sell some of the assets, but they're liquid, and that won't influence price too much).

For smaller or more exotic assets, a fund might not buy them outright, but contract with a third party (an investment bank, typically), and give the bank the money, with the bank promising that it will return the value of the asset. So, it's "like" holding the asset, except that you get the credit risk of the bank - there's a risk the bank might not be able to uphold its promise. And this is most likely to happen when everyone runs for the exit.

> The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.

> ... the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day.

So, an ETF promising to deliver the value of an index can generally do it, and there was no big failure so far, but scenarios are conceivable where it cannot deliver.

Re: Why Index Funds Are Like Subprime CDOs

#62

Post by ineedasername »

How can index funds that track the market actually distort the market? In the alternative, wouldn't the same amount of money just be invested in stocks individually? Wouldn't even a small number of active investors jump on distortions and quickly provide more accurate pricing?

Re: Why Index Funds Are Like Subprime CDOs

#63

Post by whatshisface »

noirbot wrote: post #50
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?

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…

>I'd assume there's some stability to knowing that X% of the market is passively invested in indexes.

Indexes holding shares have no influence on the price. The price only changes when traders trade.

Re: Why Index Funds Are Like Subprime CDOs

#64

Post by davidw »

perardi wrote: post #45
neilk wrote: post #38

Earlier quoted context omitted.

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.

> But everyone is a dummy in that sense.

And even honest people well versed in economics will tell you that they are too.

Re: Why Index Funds Are Like Subprime CDOs

#65

Post by jandrese »

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.

That's it exactly. If the index funds get so big that they basically are the market, then active investors will have to adjust their view of the market to be effectively just whatever the index funds do.

It may be possible that although they can't beat other active investors enough to justify their fees, they can beat a big dumb index fund enough to make their services worthwhile. That remains to be seen however.

Re: Why Index Funds Are Like Subprime CDOs

#66

Post by kgwgk »

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?

To make money you don't need to "Guess the future" in an absolute sense, you just need to "guess" better than the rest of the market participants.

When there is a majority buying/selling all the shares in block without any consideration to the differences in liquidity and fundamentals between stocks it may be easier to find opportunities than when everyone buys and sells individual stocks. (But one could also say that the average stock-picker is so bad that having more active investors actually increases the gain for the talented ones rather than pressuring profits due to competition).

Re: Why Index Funds Are Like Subprime CDOs

#67

Post by mtberatwork »

hindsightbias wrote: post #37
tjpaudio wrote: post #17

Earlier quoted context omitted.

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.

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

There are: https://www.marketplace.org/2019/08/29/meet-the-algorithms-c...

Re: Why Index Funds Are Like Subprime CDOs

#68

Post by whatshisface »

whatok wrote: post #60
whatshisface wrote: post #56

Earlier quoted context omitted.

Holding doesn't change the price: buying moves it up and selling moves it down. An index fund holding 50% of all shares on the market but not trading them would have no influence at all on prices.

Did you mean to reply to my post? I don't see the relevance.

An index passively holding 99% of the market would not interfere with price discovery because the remaining 1% would go about its business as if nothing was different. Indexes can't sustain irrational prices because they have no impact on prices.

Re: Why Index Funds Are Like Subprime CDOs

#69

Post by FabHK »

lunchables wrote: post #47
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?

Yes, and in particular they would indicate lower future returns for the equity market as a whole, but that has nothing to do with the issue here, namely ETF/index fund vs. non-ETF/index fund.

Re: Why Index Funds Are Like Subprime CDOs

#70

Post by Ididntdothis »

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?

I think the key is to have some level of luck. Then you can lecture others who didn’t have luck that they didn’t do it right but you did.
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