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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#241

Post by ISL »

peteretep wrote: post #183
drelihan wrote: post #127

Earlier quoted context omitted.

Imagine there was a cookie market made up of two types of cookies, tasty and meh. An active investor in cookies would spend time determining which cookies are likely tasty and which are meh. They would pay more for the tastier cookies so they can savor the flavor and less for the meh ones they can binge eat in the shower when no one is home.... A passive investor comes along and says, I don't want to do all this rese…

> At some point, no one is left to figure out which cookies are tasty vs meh Except that there’s a lot of money to be made by figuring out which cookies are winners, and buying them cheaply to sell to the passive investors.

A merit of the passive approach is that the act of buying tasty cookies will increase the tasty-cookie price. The passive investors' existing tasty-cookie holdings will increase in value, too.

All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced. No matter what, they have an average distribution of cookie-quality in their holdings.

The passive investors are not buying cookies at any price other than the market price. Whatever the clever-cookie-buyer is paying for cookies, they're paying the same. If a clever-cookie-buyer buys low, takes out an ad in Cookie Magazine, and sells high to a bunch of tasty-cookie aficionados, the passive investors win, too. If a too-clever-cookie buyer buys low and discovers that the apparently-tasty cookies have spoiled, the passive investors lose a little, too.

It is hard to bilk a passive investor. The first people to really figure out how will accumulate a lot of money (and ire).

Re: Why Index Funds Are Like Subprime CDOs

#242

Post by gniv »

blacksqr wrote: post #240
ng12 wrote: post #237

Earlier quoted context omitted.

> His point is that the index funds don't own the stocks at all What? Where did you see that? Not only do the index ETF issuers own the stock but I believe they are legally obligated to do so.

"Potentially making it worse will be 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. This fundamental concept is the same one that resulted in the market meltdowns in 2008."

The keyword there is "help". They use derivatives to handle the daily fund flows. They should be a tiny percentage of the whole fund value.

Re: Why Index Funds Are Like Subprime CDOs

#243

Post by KingMachiavelli »

cybersnowflake wrote: post #81

Accepting that actively managed funds are better than passive index funds is basically acceptance of the classical mentality that there are people who can consistently predict and beat the market and that you can make money by picking the 'right guy'. I assumed most knowledgeable investors abandoned that philosophy in the 80s/90s

(This is my understanding of the artical with some help from other comments. I probably use some words incorrectly but I think you can get the jist)

TLDR: He is't abandoning the current stance that passive > active but rather is discussing the real value of the underlying assets.

And he isn't challenging on that stance either. I don't think the artical is out right advocating people to switch their personal investments from a passive index fund to an active one since he & we both know that passive funds tend to do as well or better than active funds after accounting for fees.

However, the article (at least how I understood it) is saying total effect of everyone moving their money into ETFs and index funds means that the underlying stocks have an increasing risk of becoming or being overvalued since no one is checking the underlying stocks/companies anymore. As someone just tangentially interested in this topic I've thought of this before in a more tangable way: since every college graduate or hacker news type person knows that index funds are the best then at some point 'everyone' or enough of the population has a stake in index funds that it's likely to be overvalued.

The market should/could correct as expected: undervalued companies go unnoticed longer since everyone is passively investing causing actively managed funds to have higher yields (since they can get 'all' of the undervalued companies passive investors miss) and people adjust their holdings accordingly. However, as a few other users stated there a few issues trying to hedge against a buble:

1. Solvency - The market remains 'irrationally' attatched to passive/index funds which means that index funds continue to beat active funds anyway despite their 'real' value/gains being pure speculation. It's difficult convincing people to let you manage their money when your making 4% and the S&P400 is making 8-11% so remaining solvent is an issue.

2. Systemic Risk - Large markets & financial products are intertwined so if index funds are overvalued then it effects the economy & financial institutitions and if it crashes/pops then it sends a shock wave throughout all of them. Finding a hedge that isn't effected by a bubble in one financial product (CDOs, index funds, etc) can be tricky.

Re: Why Index Funds Are Like Subprime CDOs

#244

Post by mherdeg »

drelihan wrote: post #127
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…

Imagine there was a cookie market made up of two types of cookies, tasty and meh. An active investor in cookies would spend time determining which cookies are likely tasty and which are meh. They would pay more for the tastier cookies so they can savor the flavor and less for the meh ones they can binge eat in the shower when no one is home.... A passive investor comes along and says, I don't want to do all this rese…

Yeah I think the consensus is that 100% passive would be terrible.

Jack Bogle's view was that if the market is 50%+ passive indexed that would be bad news.

Some folks argue that the number is even more extreme, that passive indexing generally increases efficiency, and that as long as there are even a handful of active investors, the market will still be efficient: http://www.philosophicaleconomics.com/2016/05/passive/

The same author had another thought-provoking argument that the popularity of indexing has probably driven up stock valuations: http://www.philosophicaleconomics.com/2017/04/diversificatio...

Re: Why Index Funds Are Like Subprime CDOs

#245

Post by bigred100 »

ptero wrote: post #140
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…

I will try to interpret, but obviously it is just my interpretation (and personally I mostly agree with many theses Burry gave). First, he does not really talk about being a "good citizen" or not. His points are for "greedy citizens" who, in his view, should be worried (about his pocketbook) if he is heavily invested in passive index funds. This is due to his "bigger and bigger crowds, same exits" analogy: individual…

Aren’t index fund investors generally the folk who would just buy more during a huge exist anyway? That seems to be the “common wisdom” that goes with index fund advice.

Re: Why Index Funds Are Like Subprime CDOs

#247

Post by badfrog »

thoughtstheseus wrote: post #215
bcit-cst wrote: post #195

Earlier quoted context omitted.

One thing I am trying to understand . lets say there is a super flash crash and take Acme INC Day 1: (before crash) price : 200$ S&P 500 weight : 2% Day 2 :next day market crashes. Acme is very low volume so price crashes to 1$ . what happens next ? do all the EFT that follow S&P have to sell all ACME for 1$ because it is not in the S&P 500 anymore. Day 5 : ACME jump back to 200 $ and is back in the S&P 500. So my qu…

Index changes don’t happen like that and a drop that large would freeze trading.

There is no market rule that prevents a single stock from dropping 99% in a day. LULD only halts trading for a few minutes, then there's an auction that could result in any price.

Re: Why Index Funds Are Like Subprime CDOs

#248

Post by markbnj »

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…

> 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

The CNBC article I linked claims that actively managed funds have been beaten by the S&P 500 for _nine straight years_. How long do the investors in actively managed funds have to wait for their big celebration?

Re: Why Index Funds Are Like Subprime CDOs

#249

Post by solotronics »

dfabulich wrote: post #184
ptero wrote: post #140

Earlier quoted context omitted.

I will try to interpret, but obviously it is just my interpretation (and personally I mostly agree with many theses Burry gave). First, he does not really talk about being a "good citizen" or not. His points are for "greedy citizens" who, in his view, should be worried (about his pocketbook) if he is heavily invested in passive index funds. This is due to his "bigger and bigger crowds, same exits" analogy: individual…

That doesn't answer markbnj's question. You elaborate why the passive market is in peril (because in the event of a sell-off, the ETFs will be forced to sell a bunch of low-volume stocks, crashing them), but that's just explaining in detail that the market is in peril because not enough money is flowing to people who do a poor job of managing it. But, granting that Burry is right and you're interpreting him correctly…

Maybe one answer is a new fund type that spawns smaller funds automatically at a certain amount of capital raised which invest variable amounts in a broader group of companies.

Re: Why Index Funds Are Like Subprime CDOs

#250

Post by dclusin »

gniv wrote: post #242
blacksqr wrote: post #240

Earlier quoted context omitted.

"Potentially making it worse will be 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. This fundamental concept is the same one that resulted in the market meltdowns in 2008."

The keyword there is "help". They use derivatives to handle the daily fund flows. They should be a tiny percentage of the whole fund value.

You only find out who's swimming naked when the tide goes out.
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