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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#161

Post by kybernetikos »

davidw wrote: post #22
kybernetikos wrote: post #19

Earlier quoted context omitted.

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 investor…

> 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.

Excellent point. Indeed, I believe the academic view is that due to decreasing returns to scale, funds flow in and out of active funds, with an equilibrium only when any alpha (performance above the norm) is entirely swallowed by fees.

Re: Why Index Funds Are Like Subprime CDOs

#162

Post by edmundsauto »

nabdab wrote: post #136
markbnj wrote: post #58

Not knowledgeable on these matters, so my money is in index funds. Obviously a lot of other people are in the same category as myself. The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing. The latter is out of reach for most people, and with respect to the former it's somewhat puzzling that managed funds can't consistently outpe…

It’s all fine to say that active funds can’t outperform index funds... but if it’s a bubble and it crashes, then people in active funds will be having a field day while the people who bet it all on index funds will be left behind like the people who leveraged their 3 homes to buy 5 more during the “real estate always and consistently goes up” days of pre 2008. The problem with bubbles is that everyone’s a winner and…

This would assume that active funds exit at the right point in the crash. What if they wait to the bottom to sell? What if they sell during a temporary dip, then the market rallies (pseudo-bubble that never happens?)

Re: Why Index Funds Are Like Subprime CDOs

#163

Post by edmundsauto »

bgilroy26 wrote: post #126
motbob wrote: post #108

So there are two concerns here. One concern is a problem with a certain asset being inflated, in this case S&P 500 stocks, and the money you might lose if you hold those assets and their value goes down to normal. A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial…

I think the big moment, if it comes, is when you can envision the difference between how people value the asset in question and how that asset is actually valued. In the case of the housing market, most people in 2003 pictured suburbification and the generation of baby boomer retirement communities as inevitable economic engines. But in the same era, Arrested Development the TV show was skewering over-production of p…

Is your suggestion that overproduction of housing is what caused the bubble?

Re: Why Index Funds Are Like Subprime CDOs

#164

Post by kybernetikos »

wcunning wrote: post #97
kybernetikos wrote: post #19

Earlier quoted context omitted.

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…

The problem with that interpretation is the following: Each active investor gets some return and contributes some movement to the market. If there are enough active investors, the aggregate move of the market matches the actual value movement of the stock in a company. Then, on the sidelines, over some time period the market's moves are copied by the index (a balancing of the index). If, however, there are too few ac…

> If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well.

Passive investors are copying the average of the active investors. Just as you would never have a situation where all active investors are outperforming passive investors, you would always expect there to be some active investors outperforming the average. The big question is the extent to which individual managers can keep it up over time (and as more AUM flows into their funds) and the magnitude of their out-performance.

And you're right - as active investors find new opportunities and make money out of them, they will improve the average and hence the performance of the passive investors.

You can add up the performance of all active funds and see how they are doing as a whole. My understanding is that at the moment, the sector as a whole is doing OK, but almost all of the returns are from the top performing funds, so an active fund chosen at random is likely to be destroying value. However, this could change as more mispricing opportunities arise in the market.

Re: Why Index Funds Are Like Subprime CDOs

#165

Post by edmundsauto »

gizmo686 wrote: post #98
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?

Active investors are already really good at guessing the future. Index funds work because they follow the decisions made by active investors without needing to pay said investors. As more of the market moved to indec funds, a smaller amount will be controlled by active investors, which will make the entite market dumber (I would say less efficient, but that would include the cost of managing the fund). As the market…

I think all available evidence points to active investors NOT being good at guessing the future, when compared to the general consensus. The second half of your argument seems like an interesting opinion, but I'm curious where the evidence is for it.

Re: Why Index Funds Are Like Subprime CDOs

#166

Post by notyourday »

UnFleshedOne wrote: post #154
notyourday wrote: post #8

Earlier quoted context omitted.

When people invest money into index funds, then the funds must spend all that money buying the shares of the underlying fund companies . So that creates tons of buy orders for the underlying stocks, which creates the buying pressure, which makes the prices rise. As long as more money comes into the index funds the prices of underlying stocks will keep rising. But the higher the prices of the underlying the more money…

So, a normal decade in the markets?

A bit more exciting probably since the market is higher now which means that the oscillation will be more impressive.

The rest is chicken little - we got into that mess before because neither CDOs nor CDSs were liquid which means that as long as they were not trading banks were able to continue book them at the nominal value and since to trade them one needed to have banks that were on a hook for them to do the trade nothing was moving. That's the biggest issue with those kinds of instruments.

Nothing of sort could happen with the index funds because both the derivatives and the underlying are sufficiently liquid, so the drop won't be 100->20 but rather 100->99.9->99.8->99.7->....->20.1->20 which in turn would re-balance everything.

Re: Why Index Funds Are Like Subprime CDOs

#167

Post by thtthings »

What i think he is saying is this:

If you look at s&p 500 stocks weight for instance, at number 483 is Rollins inc, weight 0.019938%. Do you know this company? But everyone here if you have invested in s&p 500 has invested in this stocks. The way s&p 500 works is it picks stocks based on market cap. Now this company has a very low chance of getting kicked out even if it is a dud as people keep investing in it via ETF's

Here lies the opportunity. If you go through every company in s&p 500 you are going to find overvalued and undervalued stocks. One strategy is to pair trade. Take a long/short position. But it is very tough to time as every keeps investing every month. Other strategy is wait for a crash and instead of again investing in these ETF's for small returns pick stocks that got battered for no reason. This has inspired me to actually work a bit, actually looks at balance sheets and pick stocks.

Side note, i only own one etf and it is PTF. It has very little stocks and i think focused funds are a better bet.

Re: Why Index Funds Are Like Subprime CDOs

#168

Post by woodandsteel »

kgwgk wrote: post #147
ninv wrote: post #141

Earlier quoted context omitted.

What i understood was all investors are buying basket of tasty cookies and no one is buying meh cookies' basket or cookies. So tasty cookies are overvalued and meh cookies are under valued.

"And now passive investing has removed price discovery from the [cookie] markets. The simple theses and the models that get people into [cookie baskets] -- these do not require the [cookie]-level analysis that is required for true price discovery."

And the article says that is due to other factors in addition to passive investing, like central bank interest policies.

Re: Why Index Funds Are Like Subprime CDOs

#169

Post by kgwgk »

woodandsteel wrote: post #168
kgwgk wrote: post #147

Earlier quoted context omitted.

"And now passive investing has removed price discovery from the [cookie] markets. The simple theses and the models that get people into [cookie baskets] -- these do not require the [cookie]-level analysis that is required for true price discovery."

And the article says that is due to other factors in addition to passive investing, like central bank interest policies.

Where does the article say that? We may be talking about different articles...

Re: Why Index Funds Are Like Subprime CDOs

#170

Post by gizmo686 »

edmundsauto wrote: post #165
gizmo686 wrote: post #98

Earlier quoted context omitted.

Active investors are already really good at guessing the future. Index funds work because they follow the decisions made by active investors without needing to pay said investors. As more of the market moved to indec funds, a smaller amount will be controlled by active investors, which will make the entite market dumber (I would say less efficient, but that would include the cost of managing the fund). As the market…

I think all available evidence points to active investors NOT being good at guessing the future, when compared to the general consensus. The second half of your argument seems like an interesting opinion, but I'm curious where the evidence is for it.

What do you mean by "general consensus"?

If you mean "current market values", then those are being set by the aggragate opinions of active traders. If there are less active traders, there is less brainpower being devoted to finding this consensus, so it would be suprising if the consensus did not get less accurate.

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