A critique of the claim that passive investing is a bubble • Hacker News Board

Re: A critique of the claim that passive investing is a bubble

#11

Post by mrep » Thu, Sep 05, 2019, 4:03 PM UTC

talolard wrote: post #2

I think this article really misses the point that Burry was making, which is that if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down. This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don't negate the risk that is being pointed to.

How would they lose liquidity? Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit.

Even if one of the underlying stocks becomes illiquid, a big enough price divergence on all of the other liquid stocks would make it profitable to eat the loss or hold the illiquid ones (risky, but remember, there are many authorized participants competing with each other so if there is some way to make an easy arbitrage profit, they will find a way). You'd basically need the entire market to become illiquid.

[0]: https://www.investopedia.com/terms/a/authorizedparticipant.a...

Re: A critique of the claim that passive investing is a bubble

#12

Post by derivagral » Thu, Sep 05, 2019, 4:05 PM UTC

The dig at "Active Management" feels like it detracts from the article, but I guess they're playing a bit to the audience.

What I found a little more concerning is their glossing over of the liquidity risks. If everyone wants to sell an index, then at some point that index needs to liquidate shares (proportionally). Those shares won't have uniform demand, which is going to cause both price fluctuations (drops) which affect the value of the index. The fun part here too is that this can play some havoc with market-cap weighted indexes, which now need to adjust their holding %'s.

Re: A critique of the claim that passive investing is a bubble

#13

Post by ambicapter » Thu, Sep 05, 2019, 4:05 PM UTC

talolard wrote: post #2

I think this article really misses the point that Burry was making, which is that if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down. This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don't negate the risk that is being pointed to.

This was mentioned in the article

> Liquidity is not a huge problem for index funds. But, Ben, what if everyone rushes to the exits all at once? Index funds and ETFs are going to cause a massive crash!

> When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So there is literally no market impact.

Re: A critique of the claim that passive investing is a bubble

#14

Post by wbl » Thu, Sep 05, 2019, 4:05 PM UTC

secabeen wrote: post #8

0xcafecafe wrote: post #4

Earlier quoted context omitted.

What if my index fund is actually just buying and holding the underlying stock as opposed to just a price tracking entity? In that case not taker for my fund = no taker for the underlying stock right? Will this not have the liquidity risk that Bury mentions?

The index fund is holding the underlying stock, largely. The challenge is that if say 5% of their fund holders sell their shares in the fund, the fund has to sell the underlying stock to generate the cash to pay out. Most funds have a rule in their documents that if you are a large fundholder (holding 1% or more of the fund) and you sell, they can hand you stocks directly rather than selling them and giving you cash,…

So? They sell others buy. If I hear there is a squeeze and have cash I'll throw it in: who wouldn't? It's never the case that x٪ of the market can exit at once regardless of how it is owned.

Re: A critique of the claim that passive investing is a bubble

#15

Post by wbl » Thu, Sep 05, 2019, 4:07 PM UTC

derivagral wrote: post #12

The dig at "Active Management" feels like it detracts from the article, but I guess they're playing a bit to the audience. What I found a little more concerning is their glossing over of the liquidity risks. If everyone wants to sell an index, then at some point that index needs to liquidate shares (proportionally). Those shares won't have uniform demand, which is going to cause both price fluctuations (drops) which…

No they don't. Let's suppose we have A Corp and B Corp both 50٪ of the total market and A Corps price and hence market cap falls by 50٪, making it 33٪ of the total market. The holdings of a fund haven't changed but the exposure still equals the market.

Re: A critique of the claim that passive investing is a bubble

#16

Post by gzu » Thu, Sep 05, 2019, 4:08 PM UTC

His point about the increase in volume leading to price discovery is laughable. More algos than ever are trading with each other on the subsecond scale but that means nothing for long term equity values. With the rise of index tracking there are fewer than ever investors actively positioning themselves against a standard indexed allocation by picking good and selling bad stocks. Indexing is riding the boat buying everything in equal components due to market cap weight.

Re: A critique of the claim that passive investing is a bubble

#17

Post by pjmorris » Thu, Sep 05, 2019, 4:09 PM UTC

mrep wrote: post #11

talolard wrote: post #2

I think this article really misses the point that Burry was making, which is that if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down. This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don't negate the risk that is being pointed to.

How would they lose liquidity? Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit. Even if one of the underlying stocks becomes illiquid, a big enough price divergence on al…

> basically need the entire market to become illiquid.

Which came dramatically close to happening in 2008, see, e.g. [0].

[0] http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_sch...

Re: A critique of the claim that passive investing is a bubble

#18

Post by frgtpsswrdlame » Thu, Sep 05, 2019, 4:11 PM UTC

Does this guy not see the contradictions in his own argument? He simultaneously believes that active funds are doing a fine job of price discovery AND that managers at active funds who deviate too much from their (passive) benchmark are likely to be fired.

Also he jumps around Burry's arguments by focusing on liquidity and in AAPL and FB. Burry's whole point is about less liquid components at the bottom of indices which are getting dragged upward by a lack of price discovery and inclusion in widespread passive funds. Since they're market-cap weighted, this would have a cyclical component, more passive purchases -> higher market cap -> higher weighting in passive indices -> more passive purchases. This would result in another cyclical component where that cycle causes: passive fund outperformance -> increased investing in passive funds -> passive fund outperformance.

Then in an event where people start liquidating there is no one there to purchase those stocks and they've been dramatically overvalued anyways so their price gets crushed. This is specifically why Burry likes small cap active.

If you pay attention to finance discussion on this board then you've definitely heard the phrase: “The market can stay irrational longer than you can stay solvent.” The argument here is that irrationality has persisted long enough to crush most 'rational' price discoverers.

>Do you know what didn’t cause the Great Depression or Japan stock market crash or 1987 crash or 1973-74 bear market? Index funds. Index funds also weren’t around for the South Sea bubble in the 1700s. Do you know what did cause these bubbles and subsequent crashes? Human nature.

Imagine doing this but replacing 'index funds' with mortgage CDOs.

Look I'm not even saying Burry is right but the absolute inability of the finance commentariat to actually address what he's saying is giving him more credence.

Re: A critique of the claim that passive investing is a bubble

#19

Post by josu » Thu, Sep 05, 2019, 4:11 PM UTC

mrep wrote: post #11

talolard wrote: post #2

I think this article really misses the point that Burry was making, which is that if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down. This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don't negate the risk that is being pointed to.

How would they lose liquidity? Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit. Even if one of the underlying stocks becomes illiquid, a big enough price divergence on al…

>You'd basically need the entire market to become illiquid.

Yes. It has happened before.

Re: A critique of the claim that passive investing is a bubble

#20

Post by TomGullen » Thu, Sep 05, 2019, 4:12 PM UTC

If an index selloff could cause a drop in underlying stock price, wouldn't we see this effect when stocks are relegated from various indexes? Does this effect exist?